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