Question

Write 3-4 paragraphs (minimum) on various methods of detecting potential financial statement and financial reporting fraud

Answer 1

The first method of detecting potential financial statement and financial reporting fraud is through the method of financial statement analysis. Financial statement analysis entails involves analyzing the financial numbers provided in a company’s balance sheet, income statement and cash flow statement. This quantitative analysis of financial numbers is then supported by the MD&A section (management’s discussion and analysis). Properly and thoroughly reading the MD&A section of a company’s financial report will give the reader a great deal of information with regards to the tone of the management. The footnotes should also be read and examined. All this will help to discover and then examine unexpected relationships in financial information of a company. It is a financial fact that relatively stable relationships exist among the economic events impacting the financials of a company in the absence of conditions that are to the contrary. So any unexpected deviations will point to either an error or an intentional fraud.

Comparative ratio analysis can be used as another method to detect potential financial statement and financial reporting fraud. In this method different financial ratios are analyzed over a period of time. Examples of ratios that are analyzed are current ratio, quick ratio, debt ratio, interest coverage ratio, gross profit margin ratio, net profit margin ratio, accounts receivables turnover, inventory turnover, total assets turnover etc. An analysis of these ratios over a period of time can help spotting any inconsistencies if they exist. For example using inventory turnover ratio we can determine average number of day’s inventory is in stock. Any inconsistency or any significant variance in the number of day’s inventory is in stock will be a red flag and it can point to possible larceny schemes.

Vertical and horizontal financial statement analysis is yet another method for the purpose of detecting potential fraud. In case of vertical integration every item in the income statement as a percentage of revenue and we can compare the percentage trends for different years. Any anomaly or discrepancy will be a potential red flag. In case of balance sheet every item will be a percentage of total assets. Using the vertical financial statement analysis method we can find significant deviations from normal activity. In case of horizontal analysis financial information is represented as percentage of the base years’ figures. The percentage change is computed by dividing the amount of increase or decrease for each item by prior-period amount. While small and immaterial frauds will not be easily detected large and material frauds will show large deviations and in this way the fraud can be systematically discovered.

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