Comparative financial statements provide information for current and past accounting periods. Accounts expressed in whole dollar amounts yield a limited amount of information. The conversion of these numbers into ratios or percentages allows the reader of the statements to analyse them based on their relationship to each other; in addition, it allows
the reader to more readily compare current performance with past performance. In fraud detection and investigation, the determination of the reasons for relationships and changes in amounts can be important. These determinations are the red flags that point a fraud examiner in the direction of possible fraud. If large enough, a fraudulent misstatement can
affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements do not make sense when analysed closely. Financial statement analysis includes the following:
- Vertical analysis
- Horizontal analysis
- Ratio analysis
There are traditionally two methods of percentage analysis of financial statements: horizontal and vertical analysis. Vertical analysis is a technique for analysing the relationships among the items on an statement of profit or loss and other comprehensive income, statement of financial position, or statement of cash flows by expressing components as percentages of a specified base value. This method is often referred to as common sizing financial statements because it allows an analyst to compare entities of different sizes more easily. In the vertical analysis of a statement of profit or loss and other comprehensive income, net sales is the
base value and is assigned 100 percent. On the statement of financial position, total assets is assigned 100 percent on the asset side, and total liabilities and equity are expressed as 100 percent. All other items in each of the sections are expressed as a percentage of these numbers.
Vertical analysis emphasises the relationship of statement items within each accounting period. These relationships can be used with historical averages to determine statement anomalies.
Horizontal analysis is a technique for analysing the percentage change in individual financial statement line items from one period to the next. The first period in the analysis is considered the base period, and the changes in the subsequent period are computed as a percentage of the base period. If more than two periods are presented, each period’s changes are computed as a percentage of the preceding period. The resulting percentages are then studied in detail. As is the case with vertical analysis, this technique does not work for small, immaterial frauds.
The following is an example of financial statements that are analysed using both horizontal and vertical analysis:
In the example, we can observe that accounts payable makes up 29 percent of total liabilities in Year One. Historically, we might find that this account averages slightly over 25 percent
of total liabilities. In Year Two, accounts payable, as a percentage of total liabilities, increased to 51 percent. Although this increase might be explainable through a correlation with a rise in sales, such a significant increase could also be the starting point of a fraud examination. Source documents should be examined to determine the reason for the rise in this percentage. With this type of examination, fraudulent activity might be detected. The same type of change can be seen as selling expenses decline as a percentage of sales in Year Two from 20 percent to 17 percent. Again, this change might be explainable, but close examination could point a fraud examiner to uncover fictitious sales, since there was not a corresponding increase in selling expenses.
It is important to consider the dollar amount of change as well as the percentage when conducting a horizontal analysis. A 5 percent change in an account with a very large dollar amount could actually be much more of a change than a 50 percent change in an account with much less activity.
In the example, it is obvious that the 80 percent increase in sales has a much greater corresponding increase in cost of goods sold, which rose 140 percent. These accounts are often used to hide fraudulent expenses, withdrawals, or other illegal transactions.
Ratio analysis is a means of measuring the relationship between two different financial statement amounts. The relationship and comparison are the keys to the analysis. Many professionals, including bankers, investors, and business owners, as well as major investment firms, use this method. Ratio analysis allows for internal evaluations using financial statement data. Traditionally, financial statement ratios are compared to an entity’s industry averages. The ratios and comparisons can be very useful in detecting red flags for a fraud examination.
If the financial ratios present a significant change from one year to the next or over a period of years, it becomes obvious that there could be a problem. As in all other analyses, specific changes are often explained by changes in the business operations. If a change in specific ratios is detected, the appropriate source accounts should be researched and examined in detail to determine if fraud has occurred. For instance, a significant decrease in a company’s current ratio might point to an increase in current liabilities or a reduction in assets, both of which could be used to cover fraud.
In financial statement analyses, each reader of a statement will determine which portions are most important. Like the financial statement analysis discussed previously, the analysis of ratios is limited by its inability to detect fraud on a smaller, immaterial scale. Some of the types of financial ratio comparisons are shown in the following section.
Many of the possible ratios are used in industry-specific situations, but the nine comparisons described here are ratios that might lead to the discovery of fraud. The following calculations are based on the financial statement example presented earlier:
Common Financial Ratios
CURRENT RATIO = Current Assets / Current Liabilities
The current ratio—current assets to current liabilities— is probably the most commonly used ratio in financial statement analysis. This comparison measures a company’s ability to meet present obligations from its liquid assets. The number of times that current assets exceed current liabilities has long been a quick measure of financial strength.
In detecting fraud, this ratio can be a prime indicator that the accounts involved have been manipulated. Embezzlement will cause the ratio to decrease, and liability concealment will cause a more favourable ratio.
In the case example, the drastic change in the current ratio from Year One (2.84) to Year Two (1.70) should cause a fraud examiner to look at these accounts in more detail. For instance, a cheque-tampering scheme will usually result in a decrease in cash, a current asset, which will in turn decrease the ratio.
QUICK RATIO = (Cash+Securities+Receivables) / Current Liabilities
The quick ratio, often referred to as the acid test ratio, compares the most liquid assets to current liabilities. This calculation divides the total of cash, securities, and receivables by current liabilities to yield a measure of a company’s ability to meet sudden cash requirements. The quick ratio is a conservative measurement of liquidity that is often used in turbulent economic times to provide an analyst with a worst- case scenario of a company’s working capital situation.
A fraud examiner will analyse the quick ratio for fraud indicators. In Year One of the example, the company statement of financial position reflects a quick ratio of 2.05. This ratio drops to 1.00 in Year Two. In this situation, a closer review of accounts receivable shows it is increasing at an unusual rate, which could indicate that fictitious accounts receivable have been added to inflate sales. Of more concern, perhaps, is the increase in accounts payable, which at a minimum might require a closer review to determine why this increase took place.
ACCOUNTS RECEIVABLE TURNOVER = Net Sales on Account / Average Net Receivables
Accounts receivable turnover is defined as net sales on account divided by average net receivables. It measures the number of times accounts receivable is turned over during the accounting period. In other words, it measures the time between on-account sales and collection of funds. This ratio is one that uses both statement of profit or loss and other comprehensive income and statement of financial position accounts in its analysis. If the fraud includes fictitious sales, this bogus income will never be collected. As a result, the turnover of receivables will decrease.
COLLECTION RATIO = 365 / Receivable Turnover
Accounts receivable aging is measured by the collection ratio. It divides 365 days by the receivable turnover ratio to arrive at the average number of days to collect receivables. In general, the lower the collection ratio, the faster receivables are collected. A fraud examiner might use this ratio as a first step in detecting fictitious receivables or larceny and skimming schemes. Normally, this ratio will stay fairly consistent from year to year, but changes in billing policies or collection efforts could cause a fluctuation. The example shows a favourable reduction in the collection ratio from 226.3 in Year One to 170.33 in Year Two. This means that the company is collecting its receivables more quickly in Year Two than in Year One.
INVENTORY TURNOVER = Cost of Goods Sold / Average Inventory
The relationship between a company’s cost of goods sold and average inventory is shown through the inventory turnover ratio. This ratio measures the number of times inventory is sold during the period. This ratio is a good determinant of purchasing, production, and sales efficiency. In general, a higher inventory turnover ratio is considered more favourable. For example, if cost of goods sold has increased due to theft of inventory (ending inventory has declined, but not through sales), then this ratio will be abnormally high. In the case example, inventory turnover increases in Year Two, signalling the possibility that an embezzlement is buried in the inventory account. A fraud examiner should investigate the changes in the ratio’s components to determine where to look for possible fraud.
AVERAGE NUMBER OF DAYS INVENTORY IS IN STOCK = 365 / Inventory Turnover
The average number of days inventory is in stock ratio is a restatement of the inventory turnover ratio expressed in days. This rate is important for several reasons. An increase in the number of days that inventory stays in stock causes additional expenses, including storage costs, risk of inventory obsolescence, and market price reductions, as well as interest and other expenses incurred due to tying up funds in inventory stock. Inconsistency or significant variance in this ratio is a red flag for fraud investigators. Fraud examiners might use this ratio to examine inventory accounts for possible larceny schemes. Purchasing and receiving inventory schemes can affect the ratio. Understating the cost of goods sold will result in an increase in the ratio as well. Significant changes in the inventory turnover ratio are good indicators of possible fraudulent inventory activity.
DEBT TO EQUITY RATIO = Total Liabilities / Total Equity
The debt to equity ratio is computed by dividing total liabilities by total equity. This ratio is one that is heavily considered by lending institutions. It provides a clear picture of the relative risk assumed by the creditors and owners. The higher the ratio, the more difficult it will be for the owners to raise capital by increasing long-term debt. Debt to equity requirements are often included as borrowing covenants in corporate lending agreements. The example displays a very favourable Year One ratio of 0.89. Year Two, however, shows a ratio of 1.84, which indicates that debt is greatly increasing. In this case, the increase in the ratio corresponds with the rise in accounts payable. Sudden changes in this ratio might signal a fraud examiner to look for fraud.
PROFIT MARGIN = Net Income / Net Sales
The profit margin ratio is defined as net income divided by net sales. This ratio is often referred to as the efficiency ratio in that it reveals profits earned per dollar of sales. This percentage of net income to sales relates not only the effects of gross margin changes, but also changes to sales and administrative expenses. As fraud is committed, net income will be artificially overstated, and the profit margin ratio will be abnormally high. False expenses and fraudulent disbursements will cause an increase in expenses and a decrease in the profit margin ratio. Over time, this ratio should be fairly consistent.
ASSET TURNOVER = Net Sales / Average Total Assets
The asset turnover ratio is used to determine the efficiency with which assets are used during the period. The asset turnover ratio is typically calculated by dividing net sales by average total assets (net sales / average total assets). However, average operating assets can also be used as the denominator (net sales / average operating assets). The case example displays a greater use of assets in Year Two than in Year One.
By performing a financial statement analysis, the fraud examiner might be directed towards the direct evidence to resolve an allegation of fraud. After the analysis, the fraud examiner can select statistical samples in the target account and eventually examine the source documents. If an irregularity of overstatement is suspected, the fraud examiner should begin the examination with the financial statements. If, however, an irregularity of understatement is suspected, the fraud examiner should begin the examination with a review of the source documents. This rule of thumb is especially effective in the area of omission of liabilities, such as litigation, contingent liabilities, leases, and some product warranties.
The asset turnover ratio is one of the more reliable indicators of financial statement fraud. A sudden or continuing decrease in this ratio is often associated with improper capitalisation of expenses, which increases the denominator without a corresponding increase in the numerator.
Inflating revenue is the most common form of financial statement fraud. But, overstated sales most often are accompanied by inflated assets (e.g., phoney accounts receivable). This adds equal amounts to both the numerator and denominator of the total asset turnover, which affects the ratio, but not as strongly as when just a numerator or denominator are affected. Accordingly, increases in the total asset turnover have less of a correlation with overstatement of sales than do decreases with false capitalisation of costs.
Tax Return Review
Tax returns are good sources of additional and comparative information on the business’s operations. A complete review and comparison to the financial statement could provide information unknown to the lender or disclose unexplained discrepancies. Again, the lack of properly prepared or timely filed tax returns could be a method of stalling or not providing the required information. Most perpetrators of fraud are reluctant to continue the deception and falsify a tax return. Year-after-year extensions and filing of the tax returns on the last possible date could be a ploy to cover up financial statement and tax return differences.