Fraud, unlike acts of terror, murder, or bank robbery, is rarely observed. Instead, only symptoms or indicators, most often exhibited through changes in the financial statements, are present.
Financial statements summarize economic transactions and measure companies’ profitability and financial condition. If closely analyzed, the story they tell (or do not tell) can provide a powerful tool to the detection of fraud, waste and abuse. For example, financial statements that contain large changes in account balances from period to period are more likely to contain fraud than financial statements that exhibit only small, incremental changes in account balances. A dramatic increase in accounts receivable, for example, is often a signal that something is wrong. And don’t forget the footnotes, as they, too, can tell a story.
Understanding the Basics of Financial Reporting
To understand the story being told by the financial statements, it is essential to understand a few basics about financial reporting:
1. The Basic Equation – the Balance Sheet
All accounting transactions fit in one basic equation:
Assets = Liabilities + Capital
- Assets – the economic resources, including cash, inventory or buildings that will provide future benefits.
- Liabilities – the claims against those resources by creditors, vendors, employees and others.
- Capital – the residual claim against those resources by owners or shareholders.
This equation, reflected in the balance sheet, simply states that the total book value of the entity’s resources is equal to the book value of the claims against those resources as of a specific time.
2. The Income Statement
One major component of capital is a company’s profits for the current year. Profit (or net income) is computed as:
Net income = Revenues – Expenses
- Revenues (or sales) – the inflow of net assets (assets less liabilities) from selling goods or providing services.
- Expenses – the resources consumed in the process of generating revenue.
- Net income – a measure of operating performance.
When revenue is recorded, both net income and capital increase. Conversely, when an expense is recorded, both net income and capital decrease.
3. The Balancing Act
For the equation Assets = Liabilities + Capital to hold, there must be a least two parts to every transaction. Like a playground teeter-totter, if an asset increases then it must be offset for the equation to stay balanced. The offset can be accomplished in one of three ways (or a combination thereof):
- Decrease in another asset account
- Increase in liabilities
- Increase in a capital
Understanding this balancing act and the expected impact of changes would have on financial results can provide a powerful framework to identify symptoms of fraud, waste and abuse. Using this framework, in a three part blog series we will explore basic financial analysis and operating characteristics that can help to expose fraud schemes.