Dealing with financial statement frauds with J- Score

financial statement frauds

Financial Statement Frauds are the deliberate and false representation of the financial performance of the business. It could be the willful misstatement or omission of amounts or disclosures in the Financial Statements.

The resultant loss due to Financial Statement fraud is huge as it affects the Financial Statement user. One of the foremost accounting fraud cases in India was the Satyam Accounting Fraud. Satyam’s erstwhile chairman confessed to inflating the financial statements for seven years. This was one of the historical cases which highlighted the importance of forensic auditing.

One of the most popular ways in which a company can commit financial statement fraud is by overstating how much revenue it earnt during the financial year. Suppose a company is not performing as well as it would like, the senior executives may decide to inflate the numbers on the balance sheet. If the company shows that it is making good money, then people will rush to buy shares, driving the company’s share prices up. When a company earns good revenue, then it tends to give its shareholders more dividends. This is a good initiative for investing in it.

So, the main goal here is for the company to retain its old investors and attract new ones- which is how it can fish itself out of a precarious situation. Of course, it is a risky move. If the fraud is discovered then investors will pull out and the company will lose face and money, putting it in deeper trouble than before.

Forensic Rating to deal with balance sheet frauds

Satyam scam was the reason for the birth of the J-score. Launched in 2011, J-score is the base of the forensic rating model. The forensic rating model is helpful in identifying creative accounting practices. It is a statistical equation based on the financial reporting of the listed companies.

The emphasis of the forensic rating model is cash flows. It is based on the premise that you can pretend to be rich but you can’t pretend to be cash-rich. In order to understand this model, it’s necessary to understand the warning signs of financial fraud.

J-score is a simple equation that is built after an analysis of the historical cases of financial statement frauds.  Different types of financial fraud were analyzed during the process of building this equation. Income statements are the most crucial part of financial statements. Many fraud schemes revolve around income statements.

Let us consider inventory as the tool used to cook the books. This can take several forms, including fictitious inventory, overstating assets and theft of inventory, etc.

Inventory valuation throws a number of red flags such as a change in the cost of sales, inventory turnover, etc. Moreover, these red flags are converted to numerical equations by assigning weights to every such red flag in the J score calculation. More than 100 red flags associated with different elements of the balance sheet are considered in calculations.

Why do people commit Financial Statement fraud?

Many times, individuals with good financial condition commit financial statement fraud for personal gain. But the primary reason for committing Financial Statement Fraud is to make the financials of the business appear to be better. There are multiple reasons for committing Financial Statement Frauds are as under:

  • To boost the stock prices.
  • Beat the analyst’s expectations and
  • To raise money from the bankers

How are Financial Statement Frauds committed?

Financial Statement Frauds usually take place in the following four ways:

  • Overstatement of Assets to reflect a stronger company
  • Overstatement of Revenue to show fictitious growth in the company
  • Understatement of Expenses to inflate the profit of the company
  • Understatement of Liabilities to show a better picture of the company

These result in an increased net worth of the company and provide a more stable picture of the company.

However, entities sometimes even do the inverse of the above to get favorable conditions for loan settlement or show wrong insolvency conditions. Private companies not planning to raise public funds often use these tricks to avoid taxes.

How to prevent balance sheet fraud?

  • Reduce the Pressures that encourage Financial Statement Fraud
  • Reduce the opportunity to commit fraud by maintaining complete and accurate accounting records, etc.
  • Should train the employees by conducting various training seminars and
  • A proper and robust system of Internal Controls must be present in the entity.

Certification in financial statement fraud examination

The forensic rating model is globally acceptable but it has provided the best results on the Indian listed companies. It requires the details of company performance for a period of more than two fiscal years.

In order to create awareness about the fraud examination of the financial details, India forensic launched the certification program. The Certified Stock Market Forensic Accountant (CSMFA) deals with two aspects

  1. The stock market trading frauds and
  2. Financial Statement frauds

This is the only comprehensive program in India to deal with creative accounting. However, a small certification course on financial statement fraud is available for students worldwide. This program gives a bird’s overview of the subject.

In case you need any information on the financial statement frauds related certification please feel free to contact us at +919766594401.

CA Mayur Joshi
CA Mayur Joshi is a Forensic Accounting evangelist in India. He is the co-founder of Indiaforensic and is author of 7 books on forensic accounting, fraud investigations and money laundering.