Question

Illustrate how financial statement ratios can be used to detect frauds and the types of frauds they detect

Answer 1

Financial Ratios- These are the numbers which tell relationship between two or more variables or financial items. These are used to evaluate and compare the company's performance with respect to other peers. Ratios are also used to detect the fraud. Let's see how we can detect the fraud through ratios-

Account receivable versus sales- Account receivables are created when credit sales take place and customers promise to pay in the future date. Account receivable is an asset. In a company if account receivable amount is increasing and sales are not that increasing, it indicates that company has extended credit to the customers that is not a good move.

Accounts Payable vesus Sales- When company buys goods on credit, accounts payable arise. If accounts payable is more than sales, it indicates that company is either delaying payments or not able to pay its short term obligations that can be an indication of fraud.

Profit margin on sales- If sales are not increasing but profit is dramatically increasing, it means that company is inflating profit figures to show the better position of the company.

Cost of Goods sold to sales- There should be adequate relationship between COGS and sales. If there is heavy variation between the two, it dentoes heavy cost and it is also a warning sign for accounting irregularities..