Financial Statement Fraud

Financial Statement

Frau

• Error – u

nintentional misstatements or

omissions of amounts or disclosures on

financial statements

• Fraud is i

ntentional

Errors, Irregularities, and Fraud

How errors and manipulations arise

Understated

liabilities and

expenses

Type of financial statement frauds

Overstated

assets or

revenues

Financial statement analysis

se analytical procedures for high volume transactions

“As each company and project is different, selection of

analytical procedures must be appropriate to the circumstances”

“As each company and project is different, selection of

analytical procedures must be appropriate to the circumstances”

Vertical

trend

analysis

Horizontal

trend

analysis

Ratio

analysis

Source: A Guide to Forensic Accounting Investigation

Financial statement analysis (contd.)

ertical and Horizontal analysis

1. Vertical analysis

• Compares elements of the financial statement with a

common base item

• Technique for analyzing the relationships between the items on an income

statement, balance sheet, or statement of cash flows by expressing components

as percentages.

• These relationships are compared within each accounting period and then the

period under analysis can be compared with historical periods

2. Horizontal analysis

• Used to understand the percentage of change in indiv

idual financial statement

items over a period of time

• Technique for analyzing the percentage change in individual financial statement

items form one year to the next.

Source: A Guide to Forensic Accounting Investigation

3. Ratio analysis

• Assesses and measures the relationships

– among various financial statement items

– with non financial data

• Can be compared with

– Historical data

– Industry data

– Against a benchmark

• For unexpected changes - source documents and related

accounts can be

examined in detail

Financial statement analysis (contd.)

atio analysis

Source: A Guide to Forensic Accounting Investigation

Illustration

Balance Sheet Vertical Analysis Horizontal Analysis

Assets Year 1 Year 2 Change % Change

Current Assets

Cash 45,000 14% 15,000 4% (30,000) -67%

Accounts

Receivable

150,000 45% 200,000 47% 50,000 33%

Inventory 75,000 23% 150,000 35% 75,000 100%

Fixed Assets 60,000 18% 60,000 14% - -

Total Assets 330,000 100% 425,000 100% 95,000 29%

Accounts Payable 95,000 29% 215,000 51% 120,000 126%

Long-Term Debt 60,000 18% 60,000 14% - -

Stock-Holder’s Equity

Common Stock 25,000 8% 25,000 6% -

Paid – In – Capital 75,000 23% 75,000 18% -

Retained Earnings 75,000 23% 50,000 12% (25,000) -33%

Total 330,000 100% 425,000 100% 95,000 29%

Income Statement Vertical Analysis Horizontal Analysis

Year 1 Year 2 Change %

Change

Net Sales 250,000 100% 450,000 100% 200,000 80%

Cost of Goods sold 125,000 50% 300,000 67% 175,000 140%

Gross Margin 125,000 50% 150,000 33% 25,000 20%

Operating

Expenses

Selling Expenses 50,000 20% 75,000 17% 25,000 50%

Administrative

Expenses

60,000 24% 100,000 22% 40,000 67%

Net Income 15,000 6% (25,000) -6% (40,000) -267%

Financial statement analysis (contd.)

ertical Analysis v/s Horizontal Analysis - Illustration

Types of financial statement frauds

Misreporting

Misrepresentation

B. Misappropriation

of assets

Types of financial statement frauds

Misreporting

Misrepresentation

1. Timing differences

2. Fictitious revenues

3. Concealed liabilities and

expenses

4. Incorrect or misleading

disclosures

5. Incorrect or misleading

sset valuations

1. Embezzlement

2. Stealing

ypes of financial statement frauds

B. Misappropriation

of assets

Fraudulent financial misreporting

1. Revenue recognition schemes

• Most common type of fraud

• Often use to conceal real numbers of a weak quarter

Excessive number of subsequent period returns of goods,

accompanied by an unusual jump in credits

Sales have been recorded before they

were actually made

Source: Financial Statement Fraud: Detecting the Red Flags

2. Fictitious Revenue

• Posting of sales that never occurred

Red Flags

• Unusual increase in assets – mask fictitious revenues

• Missing customer records (e.g., physical address and phone

number)

• Unusual changes in ratio patterns (e.g., spike in re

venue

with no corresponding increase in accounts receivables)

Source: Financial Statement Fraud: Detecting the Red Flags

Fraudulent financial misreporting

Red Flags

• Recurring negative cash flows from operations, while

reporting earnings growth

• Invoices and other liabilities go unrecorded in the

company’s

financial records

• Writing off loans to executives or other parties

• Failure to record warranty-related liabilities

Fraudulent financial misreporting

3. Concealed liabilities

• Improper or under-reporting of expenses and other li

abilities

• Shifting expenses from one entity to another or reclassifying liabilities as assets

Source: Financial Statement Fraud: Detecting the Red Flags

Red Flags

• Disclosure notes are so complex that it is impossible to

determine the actual nature of the event or transaction

• Discovery of undisclosed legal contingencies

• Nondisclosure of pending litigations or other contin

gent

liabilities

Fraudulent financial misreporting

4. Inadequate disclosure

• Often used after a financial fraud has occurred in a

n attempt to conceal it

Source: Financial Statement Fraud: Detecting the Red Flags

Red Flags

• Unusual or unexplained increases in the book value of

assets (e.g., inventory, receivables, long term assets)

• Odd patterns in relationships of assets to other com

ponents

of the financial report (e.g., sudden changes in the ratio of

receivables to revenues)

• GAAP violations in recording expenses as assets

Fraudulent financial misreporting

5. Improper asset valuation

• Common form of profit manipulation

ource: Financial Statement Fraud: Detecting the Red Flags

1. Misappropriation of assets can be accomplished in a

variety

of ways:

• Embezzlement of receipts

• Stealing physical or intangible assets

• Causing an entity to pay for goods and services n

ot received,

etc.

2. Misappropriation is often accompanied by false or misleading

records or documents in order to conceal the fact that the

assets are missing”

Misappropriation of assets

Misappropriation of assets involves the theft of an entity’s assets and is

often perpetrated by employees in relatively small and immaterial

amounts.

Impact of fraud in the development sector

(

contd.)