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Financial Statement Analysis: A Practitioner's Guide, Fourth Edition by FERNANDO ALVAREZ, MARTIN FRIDSON

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Chapter 11

Is Fraud Detectable?

This chapter addresses the most difficult challenge to an analyst of financial statements. It is the case of a company that does not merely bend the rules, but intentionally breaks them. Often, the auditor actively participates in the fraud, thereby disabling one of the analyst's key defenses against deception. Analysts who uncover a major, flagrant violation of financial reporting standards can avert huge investment losses or produce large gains through selling short. They also can make their reputations in the process.

The discussion begins with “Telltale Signs of Manipulation,” the findings of systematic studies of financial statements of companies that misrepresented their results. Three case studies of fraudulent reporting follow, involving Enron, HealthSouth, and Parmalat. These studies explain how the frauds were perpetrated and also explore the extent to which analysts succeeded in detecting the wrongdoing.

TELLTALE SIGNS OF MANIPULATION

The aggressive accounting practices detailed in the preceding chapters may not win awards for candor, but neither will most of them land corporate managers in the penitentiary. There are many ways for companies to pull the wool over investors’ eyes without fear of legal retribution. Sometimes, however, corporate executives step over the line into illegality.

Outright misrepresentation falls into a category entirely separate from the mere exploitation of financial reporting loopholes. Moreover, the gravity ...

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