Identifying Fraud Symptoms: What Really Goes on Between the Balance Sheets? Part II

Kelly J. Todd
Managing Member
March 11, 2015

Identifying fraud symptoms in financial statements requires observation and recognition. If you don’t look, you’re unlikely to find it. Worse yet, if you do look, are you sure you will recognize the symptoms of fraud? Some of the most infamous financial statement frauds had readily observable symptoms, yet the auditors and others simply failed to recognize the signs.

Begin with a Point of Reference

Financial statements tell a story: accounts too high, too low or otherwise unusual. But relative to what? To determine if fraud symptoms exist begin with a point of reference, an expectation or some reasonable amount to which recorded amounts can be compared. One of the most practical ways to identify fraud symptoms in financial statements is to focus on changes and comparisons within the financial statements; just one piece of advice while doing this: two years doesn’t make a trend. Changes and comparisons in account balances are often more meaningful with at least three to five periods of information.

Popular Financial Statement Schemes

The most commonly manipulated accounts in financial statement fraud are revenue and/or accounts receivable. Why is this, you ask? In the words of Barry Minkow, mastermind of the ZZZZ Best fraud, “Receivables are a wonderful thing!” When you create a receivable and have revenue, you also have income and assets. The good news? Artificially inflated net income and assets generally leave a trail of symptoms.

Common Symptoms of Revenue and Accounts Receivable Schemes

  • Large, unexplained changes in accounts receivable balances
  • Unusual increases in accounts receivable aging
  • Large, unexplained increases in revenue or sales accounts
  • Sales discounts that appear too low
  • Too little cash collected from or compared to revenues being reported
  • Inadequate inventory obsolescence charges given the nature of the industry

Focusing on the Changes in Financial Statement Relationships

Examining changes in the financial statement relationships from period-to-period is one of the best ways to detect analytical symptoms of fraud. Analysis methods include:

  • Vertical analysis involves converting the components of the income statement and balance sheet to percentages and then comparing the percentages from period-to-period. In vertical analysis of an income statement, net sales are expressed as 100 percent; on a balance sheet, total assets or liabilities is expressed as 100 percent. All other items are expressed as a percentage of those two numbers.
  • Horizontal Analysis involves analyzing the percentage change in individual financial statement accounts from period to period. The first year in the analysis is considered the base year and subsequent years are computed as a percentage of the base year.
  • Ratio Analysis are summary calculations of significant relationships in the financial statements.

Check back for Part III, where we will explore common ratios and operating characteristics that can help to expose fraud schemes.