Irrational Ratios

Financial statements tell a story,” says accounting professor W. Steve Albrecht, “and the story should make sense.” If not, it’s possible the story is a fake. By standing far enough back from the numbers to get a good picture of the client’s business, auditors frequently can detect signs of financial statement frauds. Because the balance sheet, income statement and statement of cash flows are interrelated, such frauds can pop out when certain numbers don’t make sense. The inescapable logic of the accounting equation ensures that any major overstatement of assets or profits, such as in the infamous ZZZZ Best case, will show up over time.

Riding in the back of a taxi from the Federal Correctional Institute in Englewood, Colorado, to the Denver airport, I held a videotape in my hand. Two hours earlier, I had recorded the story of the legendary Barry Minkow, the “boy wonder” who, in the mid-1980s, had conned his investors and auditors in a $100 million financial-statement fraud scheme. I planned to use the video to train auditors. Minkow, who had volunteered for the interview, told me everything—something he’d not done even for “60 Minutes.”

For the briefest moment I thought, Minkow really is a pretty nice guy; then I smiled ruefully and shook my head. One of the greatest con artists of all time had just charmed an experienced (read: cynical) fraud examiner. But that is the nature of such tricksters: they appear bright, articulate, sincere and likable. Barry Minkow was certainly that—and much more.

Minkow had started a carpet-cleaning business in his parent’s garage when he was only 13. Within five years, ZZZZ Best Carpet Cleaning Service went public. But the company was built entirely on Minkow’s lies. By the time he was 20, the fraud had been uncovered and Minkow was sentenced to 25 years in federal prison (he served eight years before being paroled).

BORN TO COMMIT FRAUD?

Minkow said that, although he didn’t know exactly why, he’d been committing fraud almost since the day he opened for business. In the early days, when he couldn’t meet payroll, he’d steal checks and deposit them in his bank account. He also would kite checks, overbill customers and overdraw his checking account—whatever it took to stay afloat. What made Minkow believable was his verbal ability. After three decades of meeting and dealing with white-collar criminals, I would put Minkow at the very top; he is without question one of the most persuasive crooks I have ever met.

Minkow’s early frauds had escalated to the point where, to keep from being discovered, he had to get outside financing. The first time he borrowed money, it was on the strength of inflated, unaudited financial statements and altered tax returns. When that loan came due, he borrowed from another bank using the same method. He did the same with the next bank—and the next. Finally, when his bank financing ran out, Minkow came up with the idea of going public. It was the only choice he had to avoid discovery. So he and his lieutenants created a mountain of phony documents to fool the auditors. The bulk of the fraud was concentrated in ZZZZ Best’s sales and receivables, most of which were fictitious.

The silver-tongued Minkow managed to get past the audit. With the millions raised in the public offering, he was able to cover his previous frauds, and ZZZZ Best seemed poised to grow even bigger. Then he had a piece of bad luck. A disgruntled carpet-cleaning customer—suspicious of Minkow’s business practices—contacted a Los Angeles Times investigative reporter. The deeper the reporter dug into Minkow’s background, the more sinister the story became.

When a front-page article detailing Minkow’s questionable past and his attempts to bilk numerous carpet-cleaning customers through double and phony billings hit the newsstands, Wall Street reacted. Trading in ZZZZ Best stock was suspended. With no further funds to cover the frauds, the company quickly collapsed. The audit firm paid millions for its failure to uncover Minkow’s crimes. Investors lost a reported $100 million. When it was over, the assets of ZZZZ Best—all of them—were sold for less than $50 thousand.

THE NUMBERS DON’T LIE

The most basic analytical techniques (vertical, horizontal and ratio analyses) might have given the auditors for ZZZZ Best some important clues. Since these techniques compare changes in the numbers from year to year, they can point out significant discrepancies. In the ZZZZ Best case, look at what a simple ratio analysis would have revealed (see exhibit 1, below).