Academic journal article Fordham Journal of Corporate & Financial Law

Financial Fraud: Accounting Theory and Practice

Academic journal article Fordham Journal of Corporate & Financial Law

Financial Fraud: Accounting Theory and Practice

Article excerpt

ESSAY

FINANCIAL FRAUD: ACCOUNTING THEORY AND PRACTICE*

SECURITIES INVESTMENT MODEL

Investors purchase equity securities in the expectation that their investments will increase in value two ways - through dividends and through appreciation in the market value of the securities. Market value can be influenced by many factors, but in the main the value of equity securities is based upon the profitability of the enterprise. Value may be measured and predicted by: (a) consideration of past (i.e., historical) performance; (b) assessment of current results of operations and financial condition; and (c) evaluation of likely future results. Some metrics of corporate performance - past, present, and future - are accountin measures such as:

* Revenue and revenue trends

* Profit margins

* Earning and earnings trends

* Cash flows from operations and expected future cash flows

Other indicators of potential value may include: known or anticipated market success of products and services; market share; competitive factors (such as intellectual property rights, management quality, customer base, channel of distribution, or effectiveness of supply chain and manufacturing resources); and technological advantage. These value indicators are proxies for operating results, in that they are expected to result in increased value of equity securities because of their inherent ability to create revenue growth, control costs and expenses, achieve supererogatory profit margins, and - ultimately - obtain increased profitability.

Risk is a factor in all equity investments. The most basic risk is that future outcomes - in terms of results of operations, profitability, and share value - will not meet expectations. Risk also may be associated with volatility of revenues or any other accounting metric, or of underlying stock value, or with uncertainties relating to: exogenous economic factors; markets, market share, and competitive behavior; liquidity and the ability to produce and sustain necessary cash flows (and obtain necessary financing); management judgment; and changes in technology and in customer preferences.

Investors use financial information to assess operating results, make judgments about probable future performance, and evaluate non-accounting factors within the framework of a microeconomic and financial model of the enterprise in which an investment might be made. Thus one of the greatest risks to investors is the risk that the financial information upon which they rely is materially misstated. Financial information may be misstated erroneously or intentionally. When such financial information is misstated by any scheme, artifice, or device with the intent to mislead investors, this is a form of financial fraud.

OVERVIEW OF FINANCIAL INFORMATION

The basic form of financial information used in U.S. capital markets is general purpose financial statements, which include balance sheets (or statements of financial condition); profit and loss statements (also known as "P&Ls", or statements of operations); statements of changes in equity; statements of cash flows; and footnotes that provide additional information concerning: (a) accounting policies and procedures used to prepare the financial information contained in the financial statements; (b) the nature and composition of balances shown in the financial statements; and (c) other significant matters requiring disclosure in order for the financial statements to present fairly the results of operations and financial condition of the reporting entity. Most U.S. securities registrants are required to file certain financial information with the Securities and Exchange Commission ("SEC") in various annual, quarterly, and periodic filings, including Annual Reports on Form 10-K and Quarterly Interim Reports on Forms 10-Q.1 A company's Annual Report on Form 10-K also is required, by SEC rules and regulations, to include additional and supplemental information in the nature of: (a) certain statistical information; (b) descriptions of the company's business, products and services, plant and properties, major operating units and their locations, and significant risk factors; (c) management's discussion and analysis of operations (also known as "MD&A"); (d) an assessment of liquidity and liquidity risks; and (e) certain supplementary schedules (e. …

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