Financial statement schemes that artificially improve the appearance of company financials can be one of the costliest forms of fraud for victimized companies. Despite the passage of Sarbanes-Oxley, intentionally misrepresenting an organization’s financial condition by omitting or misstating amounts or information to deceive auditors, shareholders and the public is all too common.
Root out anomalies
In general, financial statement fraud perpetrators are high-level employees, usually executives, with significant financial and accounting knowledge. For example, a CFO might record sales of goods or services that never occurred to artificially inflate revenues. Or a CEO 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%. If rental expense has increased significantly but sales hasn’t 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 2 minus Year 1 divided by Year 1. So if rental expense equals $117,000 in Year 1 and $198,000 in Year 2, the percentage change is ($198,000 – $117,000) / $117,000, or 69.2%.
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 isn’t 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.
With the proper knowledge about financial statement fraud red flags and how to detect it, you can protect your company from unscrupulous accounting practices. For more information about preventing financial statement fraud or if you suspect fraud has already been committed, call us at 949-860-9902 or click here to contact us.