Forensics Journal - Stevenson University 2015 | Page 61

FORENSICS JOURNAL

In the case fraudster Barry Minkow, founder of ZZZZ Best
CarpetCleaning Company, he used fictitious receivables to present
to banks whenever he needed to borrow money. During an interview
with the President, Association of Certified Fraud Examiners, Joseph
T. Wells, Minkow described his thought process as he committed one
dishonest act after another. Minkow described how easy it was for
him to use receivables to borrow money from the bank because not
only could he show the bank a receivable but also fictitious revenue
since the two accounts were offsetting (GAAPquest, 2010). If any
of the company’s accountants, bankers, or stock analysts had applied
the DSR index to ZZZZ Best Carpet Cleaning Company’s 1985
and 1986 financial statement information it would have revealed
that its DSR was over 177,622 (Wells, 2001). This DSR index
would have been a significant red flag indicating that something
about this company’s receivables and sales looked unusual.

analysts consider CFI or some variation of this measurement to be a
good indicator of a company’s overall earnings quality. Good quality
earnings are not distorted by one-time, non-recurring, accounting
charges subject to manipulation. Poor quality earnings are unreliable
and unpredictable (Mulford & Comiskey, 2002).
The rationale of the forensic analyst who uses this measure as a way
to identify potential fraud is that a company’s net income should be
logical in relation to its reported operating cash flows. If a company is
operating under normal business conditions for five straight quarters,
and then suddenly records one quarter of fictitious revenue, then that
revenue will never appear as part of the operating cash flow. Instead,
the company will likely off-set the fictitious revenue with a receivable
account, and ultimately write-off the receivable during the next
few quarters. Under this scenario since net income rises faster than
operating cash flow, the CFI ratio decreases. This decrease is likely to
be significant if the fraud is material. When net income rises slower
than operating cash flow, the ratio increases. If the fraud is material,
then the corresponding increase in CFI is likely to be significant
(Mulford & Comiskey, 2002; ACFE, 2007).

Apparently, no such analysis occurred as a significant number of
sales and receivables were fictitious. In 1982, ZZZZ Best began
operations as a legitimate carpet cleaning business. However, as the
company became less successful, Barry Minkow used deceit and lies
to hide the truth behind the company’s lack of success (Akst, 1087).
The deceit continued as his company went public in January, 1986
and Minkow lied to auditors, regulators and the public about the
true nature of the company’s operations (Akst). He said the company’s
core business had changed from carpet cleaning, (20%) to building
registration (80%) thus increasing earnings (Akst). Minko had to
create a plausible explanation for the overall rise in earnings, revenue,
and profit. In 1984, ZZZZ Best earned $1.3 million, which was
generated through its carpet cleaning services. However, by July 1986,
the company’s sales had grown to $5.4 million (Akst). The restoration
business was used as a front to explain the company’s strong sales
growth and allow Minkow to continue borrowing money (Akst).

An illustration of how CFI can be used in financial statement analysis
occurred in HealthSound:
In 1998 the cash flow to net income ratio of HealthSouth
jumped from 1.3 the previous year to 14.95. The next year
it dropped somewhat but was still way above average at 9.21.
In fact, the subsequent investigation revealed that management
had been misclassifying the provision for doubtful accounts by
adding to it in rich earnings years and debiting it to increase
earnings in flat years (ACFE, 2007).
MATHEMATICAL, STATISTICAL MODELS

Figure 3

Z-Score
There have been ongoing efforts by members of the business and
academic community to better analyze financial reporting by public
companies. A good understanding of financial reporting helps in
the development of models that more accurately detect financially
vulnerable companies. The Z-Score methodology assists in identifying
companies that are at risk for bankruptcy.

Accounts Receivable p1
Sales p1
Where:
P1 = current period
P2 = prior period

= Days’ Sales Receivables Index

Accounts Receivable p2
Sales p2

Source: Irrational ratios: The numbers raise a red flag (Wells, 2001).

In 1968, the Z-Score was developed by Edward Altman, Assistant
Professor of Finance at New York University. Although the model
was initially developed as a way of measuring a company’s financial
health, it can also be useful when analyzing companies for potential
fraud. The Z-Score is limited in scope in that it only applies to
manufacturing companies, and cannot be applied across a broad
spectrum of organizations. Overall, the model provided a high rate
of accuracy. In fact, “In its initial test, the Altman Z-Score was found
to be 72% accurate in predicting bankruptcy two years prior to the
event. In subsequent tests over 31 years up until 1999, the model was

CFI Index
Measuring a company’s Operating Cash Flow to Net Income (CFI) over
time is another method to detect fraudulent financial reporting. The
reason for this is because it is much easier for company’s management
team to manipulate accounting net income than it is for them to
manipulate cash flows from operations. Since cash flow is not as
easily manipulated as net income and is expected to have ͽ