Spotting Financial Statement Fraud, Part 3: Red Flags

In our first two articles in this series about financial statement fraud, we explored how and why a trusted individual might commit fraud and common methods that are used.  We conclude this article series by summarizing important methods to detect when financial statement fraud is occurring at your own business or with a trusted trading partner.

Fortunately for those seeking to uncover financial statement fraud, whether within their own company or in a potential partner, creditor, or debtor, there are a number of red flags.

Chuck Curl, director of regulatory, risk and compliance at RPE, Inc. in Bancroft, WI, has learned many things to look out for when examining a financial statement.

“We start by doing a vertical analysis of the statement by reviewing the balance sheet, to evaluate the equity position of the company,” Curl explains. “We use the same approach when analyzing income statements to look at gross profitability and operating income.”

There are also accompanying questions: Is the company profitable, and has it maintained profitability over a long period of time? Has there been a marked degree of change in liability from one year to the next, or has there been a large, unaccounted-for shift in liquidity ratios?

Curl’s approach is in keeping with the advice given by industry experts for spotting financial statement fraud. Most fraud, no matter how clever or well concealed, is still likely to trigger a few red flags with a close reading of a company’s financial statements.

Among these red flags are unexplained jumps in revenue (substantial increases in profit should always be accompanied by a matching boost in cash flow; if cash flow has remained steady but revenue has jumped, this could be a warning sign) and major alterations to assets and liabilities (new assets or liabilities without an explanation or an accompanying capital expenditure plan might be concealing fraud at some level).

Another indicator are suspiciously large bonuses or loans, particularly in firms that do not regularly loan money or pay bonuses, where the presence of big payouts can be used to hide liability or conceal unaccounted-for income.

In addition, late–term spikes in earnings or revenue can be suspicious in companies with fairly steady patterns of income, if there’s a significant surge in earnings towards the end of the fiscal year, it might be worth taking a closer look.

Lastly, another possible red flag is little cash on hand—if a financial statement includes record profits, high valuations, or new revenue but very little cash on hand for bills and other expenditures, there may be a problem.

FRAUD DETECTION

It’s one thing to learn the warning signs of financial fraud, but it’s much more difficult to actually prove it is occurring. Three of the most common methods of fraud detection include vertical, horizontal, and ratio analysis.

Vertical analysis, also referred to as “common-size analysis,” is a method of examining financial statements by showing each item as a percentage of a base figure, often sales figures, total assets, or liabilities and stockholder equity.

Once this baseline number is established, all other entries in the financial statement (taxes, operating expenses, net income, sales costs, and so forth) are expressed as a percentage of this figure.

Horizontal analysis or “trend analysis,” has been steadily gaining converts over vertical analysis. Here, items in a financial statement are assessed by the degree to which they have changed over a period of time.

By comparing the same items over two or more periods, analysts are able to make predictions about the likelihood of growth or decline, but just as crucially, to see large discrepancies or unpredictable patterns.

Lastly, there’s ratio analysis, which is more sophisticated than vertical or horizontal. It’s an in-depth analysis that classifies financial ratios on the basis of function, such as liquidity, profitability, and solvency.

Each ratio is calculated by using several different data points and weighted against the overall total, with some (such as solvency) more stable and predictable than others (such as liquidity); these are then classified on the basis of importance.

CONCLUSION

Financial statement fraud can come in many forms and most is not easily detected. Industry experts generally agree that creating and following a set of best practices gives companies a solid foundation for combating fraud.

Working with industry and national credit agencies is another step in the right direction, as these firms have a great deal of available information.

“More often than not, we will rely on credit reporting agencies to collect, verify, and analyze financial information,” notes Curl. “The preference would be to rely on audited statements to avoid deceptive submissions or use accredited credit rating services to vet out this information. And, of course, financial reports submitted to the SEC.”

Employee training is also crucial, with regular reviews of transactions and accounting estimates. But perhaps the most important tool to prevent financial impropriety is trust. The tone should be set at the top of the organization and management should lead by example, ensuring all associates feel comfortable to report irregularities, no matter how small or seemingly insignificant.