18 Dec Tools for Uncovering Financial Statement Fraud
Financial statement fraud is committed by intentionally misrepresenting an organization’s financial condition. A perpetrator might do this by omitting or misstating amounts or information to deceive auditors, shareholders, and the public. However this fraud is committed, it tends to be one of the most costly schemes for the victimized companies.
Root out anomalies
In general, financial statement fraud perpetrators are high-level employees, usually executives, with significant financial and accounting knowledge. For example, a chief financial officer might record sales of goods or services that never occurred to artificially inflate revenues. Or a chief executive officer might fail to disclose a significant liability that would cause the company’s stock price to fall.
Not surprisingly, financial expertise is essential to rooting out this crime. Forensic accountants look for financial statement anomalies using various tools, including:
Vertical analysis. Also referred to as ‘common sizing,’ this method involves dividing each line item by net sales to arrive at a percentage. For example, if net sales equals $900,000, an expert would divide the company’s rental expense of $117,000 by that number to arrive at 13 percent. If rental expense has increased significantly but sales has not followed, this could indicate that the company is inflating its costs to minimize taxable income.
Horizontal analysis. Here, an expert reviews percentage changes in line items over time. Determining the percentage change from one year to the next involves applying the following formula: Year two minus year one divided by year one. So, if rental expense equals $117,000 in year one and $198,000 in year two, the percentage change is ($198,000 – $117,000) / $117,000, or 69.2 percent.
Ratio analysis. This tool helps explore the relationship between financial statement line items. For instance, an expert might divide current assets by current liabilities for each reporting period to come up with a ratio that suggests that current assets such as accounts receivable or cash have been manipulated.
Analyzing individual line items within a reporting period is not the only way to find financial statement fraud. Take the example of a perpetrator who prepares deceptive financial statements yet reports accurate amounts to the government. A forensic accountant would simply compare the statements with the company’s tax return.
Depending on the company and specifics of the fraud, other detection methods are available.