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Sarbanes Oxley : Finance : Analysis
Financial Hieroglyphics - The Numbers Speak To Me
By
Darrell Dorrell
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Darrell Dorrell
Principal and Founder
Financial Forensics
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Background
Hieroglyphics are enigmatic to all but the Egyptian archaeologist who declares that “…the hieroglyphics speak to me.” Yet hieroglyphics only “speak” to highly skilled, deeply trained and heavily experienced archaeologists who know how to look beyond and behind their meaning.
Likewise, financial statements contain abundant data, some of which is self-evident but much of which lies undetected and even camouflaged. Consequently, forensic accounting techniques must be deployed to harvest their aggregate contents.
This article summarizes a few of the 200-odd forensic accounting techniques that detect and diagnose unbiased indicators regarding financial condition and outlook that would otherwise be undisclosed.
“Unbalanced” Financial Statements
A subtle “imbalance” exists within today’s financial statements. That is, although the balance sheet and income statement can be traced back at least 500+ years , today’s cash flow statement has been in place less than 25 years . But the cash flow statement contains data simply not provided by any other financials.
The abundance within the cash flow statement content is usually diluted since most companies opt to report via the “indirect” versus the “direct” method. Consequently, the cash flow statement’s embedded knowledge must be explored and extracted via forensic accounting techniques. Then, when combined with balance sheet, income statement and footnote findings, the financial statements can truly “speak” to the reader.
90-Second Assessment
Financial statement forensic accounting is initiated by a 3-step “90-second” assessment. Then, depending upon findings successive drill-down investigation will discern financial veracity. The 3 steps to follow include:
Audit Opinion – As a general rule, “the longer the opinion the less reliable the financials.” Therefore, scan the audit opinion and determine whether to review it based upon the following guidance: If the opinion is comprised of only 1 or 2 paragraphs, don’t read it - it contains standard language. If the audit opinion contains 3 paragraphs, read the 3rd paragraph. If the audit opinion contains 4 paragraphs, read the 3rd and 4th paragraphs carefully. If it contains 5 paragraphs get very interested in the entire opinion, etc.
We were once engaged in a matter where the audit opinion (prepared by a Big 6 accounting firm) of a $20 million litigation claim comprised 3½ pages. Nearly 2 weeks’ work was required to “translate” the audit opinion, but it basically stated: “Except for 98% of the costs of this project, it meets the contractual requirements.” Upon explanation to the court a motion for summary judgment was rendered against the accounting firm’s opinion.
Financial Statement Nomenclature - As a general rule, “the more that numbers fall outside the framework the less reliable the financials.” Therefore, observe any below-the-line items on the balance sheet and the income statement; e.g., non-operating assets and extraordinary income/expense, respectively. The descriptor used for line items can be very telling. For example, one company reported one-time extraordinary write-offs for operations for 6 of the last 10 years! Even though their audit opinion appeared standard such nomenclature indicates potential earnings “management .”
Even the absence of nomenclature can be telling. For example, very few companies report material contingent liabilities, explaining in the footnotes that per FASB 5 no recognition is required. However, such decisions may be crucial in threshold situations, i.e. when solvency tests are marginal and virtually any reported amount would be sufficient to tip the scales.
Count/Compare the Footnotes - As a general rule, “the more obfuscatory the text the less reliable the financials.” Therefore, count/compare the footnotes. That is, if Year 1 contains 22 footnotes and Year 2 contains 37 footnotes that may indicate significant financial statement events or impact not self-evident from the financials.
Alternatively, if Year 1 contains 22 footnotes and Year 2 also contains 22 footnotes that might indicate few significant changes. However, it is still necessary to compare the textual content of each footnote. For example, if Year 1, footnote 11 contains 1 paragraph, but the same Year 2 footnote contains 5 paragraphs, the contents require scrutiny since tortured and obfuscatory language may be hiding significance.
Cash Is King
Regardless of your 90-second assessment findings your next step should be to conduct a cash realization ratio. The cash flow statement is arguably the single, most important financial statement by which to assess reporting veracity. Also, it can be considered the most “difficult” statement to misstate, particularly over time.
The reasons for such focus relate to the “articulated” nature of the balance sheet, income statement and the cash flow statement. That is, if a transaction is reported within the balance sheet and/or income statement it will be reflected in the cash flow statement . Therefore, you can expect a strong correlation between “reported” net income and “resultant” cash from operations.
Naturally, a lag may occur due to the accrual nature of net income, and cash might be impacted by capital structure changes. Nonetheless a correlation should be discernable, thus lending strength to reported net income and financial veracity.
There are various forms of cash realization ratios, but they are generally expressed similar to the following formula.
Cash Realization Ratio (CRO) = Operating Cash / Net Income.
CRO measures the ratio of operating cash in Year 1 relative to net income in Year 1. The measurements will vary greatly by industry and will usually be less than 1.0. However, the subject company’s ratio should remain relatively consistent and ideally should increase over time commensurate with reported net income.
Various refinements of operating cash can include addition of deprecation and/or amortization and related adjustments depending upon the nature of the subject’s industry. Regardless, the correlation between cash from operations and reported net income should hold true.
Even more precise measurements will be obtained using quarterly financials and can highlight end-of-year variations that suggest earnings management.
Other Key Techniques
Other key (but by NO means exhaustive) analytical techniques are detailed in “The Detection of Earnings Management ,” by Professor Messod D. Beneish, Harvard University. Professor Beneish’s paper delineates his “M” Score (not reproduced here) which has some similarities to the Altman “Z” Score, but comprises non-bankrupt entities. The following items summarize Professor Beneish’s forensic accounting techniques.
Asset Quality Index (AQI) =
(1-Current Assets t + PPE t / Total Assets t) / (1-Current Assets t -1 + PPE t -1 / Total Assetst-1)
AQI measures the ratio of asset quality in year “t,” relative to asset quality in year “t-1.” If AQI is greater than 1.0 it indicates a potential increase in cost deferral and/or perhaps an increase in intangible assets resulting from acquisitions.
AQI measures the ratio of non-current assets other than property, plant and equipment (PPE), to total assets. It indicates the proportion of total assets which are potentially less certain. Therefore, one can expect a positive relation between AQI and the probability of earnings manipulation.
Depreciation Index (DI) =
(Depreciation t-1+Net PPE t-1) / (Depreciation t +Net PPE t)
DI measures the ratio of the rate of depreciation in year “t-1” to the rate of depreciation in year “t.” The depreciation rate is comprised of depreciation expense and net PPE.
A DI greater than 1.0 suggests that the rate of depreciation has slowed, thus indicating changes to estimated useful lives or new methods. Therefore, one can expect a positive relation between DI and the probability of earnings manipulation.
Days Sales in Receivables Index (DSRI) =
(Receivablest /Sales t ) / (Receivables t-1 / Sales t-1)
DSRI measures the ratio of days’ sales in receivables in year “t” to days’ sales receivables in year “t-1.” Assuming that major changes in credit policies have not occurred the measure indicates whether receivables and revenues are in or out of balance in two consecutive years.
Gross Margin Index (GMI) =
(Sales t-1– CGS t-1) / Sales t-1
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(Sales t – CGS t) / Sales t
GMI measures the ratio of gross margin in year “t-1” to gross margin in year “t.” When GMI is less than 1.0 gross margin has deteriorated which could indicate skimming of receipts. When GMI is greater than 1.0 gross margin has increased which could indicate earnings manipulation.
Sales Growth Index (SGI) =
Sales Growth Index= Sales t / Sales t-1
SGI measures the ratio of sales in year “t” to sales in year “t-1.” Pressure to achieve results can result in overstating sales via various means.
SGA Expenses Index (SGAEI) =
SGAEI t / Sales t
SGAEI measures the ratio of SGAEI in year “t” to SGAEI in year “t-1.” A disproportionate increase in sales unexplained by events such as a major acquisition can indicate manipulation.
Leverage Index (LI) =
LTD t + Current Liabilities t / Total Assets t
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LTD t-1+ Current Liabilities t-1 / Total Assets t-1
LI is the ratio of total debt to total assets in year “t” to the ratio of total debt to total assets in year “t-1.” LI greater than 1.0 indicates an increase in leverage. The index may identify debt covenant constraints affecting earnings manipulation. Therefore, it may implicitly measure the leverage forecast error.
Total Accruals to Total Assets (TATA) =
(Current Assets t – Current Liabilities t) – Cash t – Current LTD t – Income Taxes Payable t – Depreciation & Amortization t
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Total Assets t
TATA is comprised of the change in working capital, less cash and depreciation/amortization. Year-to-year changes may indicate earnings manipulation resulting from management accrual decisions, particularly short-term decisions. Higher positive accruals (excluding cash) are correlated to earnings manipulation likelihood.
Conclusion
Forensic accounting techniques are similar to medical techniques. That is, a physician assesses his patient’s health by measuring his vital signs over time, e.g. cholesterol, BMI, et al against 2 benchmarks: the patient’s personal history (i.e. is the patient’s cholesterol improving or worsening), and the patient’s peer group, e.g. 43-year old Caucasian females.
Likewise, forensic accounting techniques can yield financial condition insight that would otherwise be lost.
Darrell Dorrell
Principal and Founder
Financial Forensics
Darrell D. Dorrell, CPA/ABV, MBA, ASA, CVA, DABFA, CMA is a principal and founder of financialforensics® in Lake Oswego, OR, a boutique forensic accounting firm. Darrell has practiced exclusively in the forensic accounting, litigation and valuation related expert witness arena since 1977, and is a nationally recognized author and speaker on such matters.
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