Financial Statement Analysis, 5th Edition

CHAPTER 11Is 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. Sometimes 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 by selling short. They also can make their reputations in the process.

Frauds as colossal as some discussed in this chapter have become rarer in the United States since passage of the Sarbanes‐Oxley Act of 2002, popularly referred to as “Sarbox.” That legislation required chief executive officers to sign their companies' financial statements, making them more prosecutable and less able to shift responsibility for accounting fraud than formerly. For analysts specifically looking for stocks to sell short for large profits, however, good opportunities continue to appear in other countries.

Furthermore, financial reporting fraud has not completely disappeared in the United States. As explained in the Preface, chief executives of some companies that intentionally misrepresented their results have successfully shielded themselves from Sarbox‐based prosecution via subcertification of the statements they signed.

In 2016, though, the Financial Times reported that the U.S. Securities and Exchange Commission ...