General Techniques for Financial Statement Analysis
How to Detect and Prevent Financial Statement Fraud
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A fraud examiner analyzes this ratio for fraud indicators. In year one of the example, the company
balance sheet reflects a quick ratio of 2.05. This ratio drops in year two to 1.00. In this situation, a closer
review of accounts receivable shows that they are 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 that might require, at a minimum, a closer review to determine why. If the drop in
the ratio indicates a problem customer or significant slowing in the time to collection, it might reflect a
general decline in company prospects. That, in turn, would be a red flag that management could feel
pressured to report fraudulent financials.
Debt-to-Equity Ratio
The debt-to-equity ratio is computed by dividing total liabilities by
total equity. It indicates the proportion of equity and debt a
company uses to finance its assets. Because the ratio provides a
picture of the relative risk assumed by the creditors and owners, it is heavily considered by lending
institutions. The higher the ratio, the more difficult it will be for the owners to raise capital by increasing
long-term debt, and the greater the risk assumed by creditors. Debt-to-equity requirements are often
included as borrowing covenants in corporate lending agreements. The example displays a year one ratio
of 0.89. This is very favorable, as it shows that the company is financed more by equity than by debt.
However, year two shows a ratio of 1.84, meaning that debt is greatly increasing relative to equity. In
this case, the increase in the ratio corresponds with the rise in accounts payable. Sudden changes in this
ratio may signal a fraud examiner to look for fraud.
Profit Margin Ratio
The profit margin ratio is net income divided by 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 examines not only the effects of gross margin changes, but also changes in selling
and administrative expenses. If fraud is committed, net income may be artificially overstated, resulting in
a profit margin ratio that is abnormally high compared to other periods. False expenses cause an
increase in expenses and a decrease in the profit margin ratio. This ratio should be fairly consistent over
time.
In this example, the profit margin analysis is already calculated in the vertical and horizontal analyses.
While revenues increased by 80%, the cost of goods sold increased by 140%; this, in turn, dropped
profit margins from 6% to –6%. Further investigation could uncover fraudulent accounting that shifted
costs from one period to another, or might reveal another type of fraud in which inventory is being
stolen so costs appear to jump.