Question

Common tools of financial statement analysis such as horizontal analysis, vertical analysis and ratio analysis have helped to uncover fraud by identifying amounts that are out of line with expectations. Discuss how these tools can help to identify fraud schemes early and whether they are useful in preventing frauds overall.

Answer 1

Horizontal Analysis : Under it some selected variables like Purchase, Sales, Revenues, Assets / Liabilities etc., of two or more years are arranged side by side horizontally for 2 years or more. The increase / decrease can be easily located. The percentage change can be found out and the trend can be detected. In this method Comparative financial statements is prepared to analyse the performance of the company. It is the historical summary of the same item or group of items related to consecutive income statement or balance sheet of a concern. It is a tool that indicates change in each item of the financial statement. It provides useful information regarding -

(a) the profitability position of a business;

(b) changes in every item involved in the determination of profits; and

(c) the weakness or success of the areas contributing towards profits.

(d) It identifies the strong and weak areas in the structure of costs and other factors determining profit.

(e) It guides to locate the areas which need exercise of control.

In this way horizontal analysis helped to uncover fraud.

Vertical Analysis : Under it the Balance Sheet total is taken as 100. Each liability and asset is expressed as a percentage of the total. From the revenue statement, net sales is taken as 100. Each individual revenue or expense is expressed as a percentage (out of 100).

Then a comparative analysis of the structural relationships like profit to sales or Shareholders’ Equity compared to Total Debts etc., is made. It is a numerical relationship between related figures. Under this method a Common size financial statements is prepared where all the components of a financial statement are expressed on a common basis. The items or components are stated aim absolute figures. But different companies have. different volumes of capital investments, profit margins, assets, sales and costs. For a meaningful comparison among different components of two or more different companies, their Balance Sheets and Income Statements are common-sized. Common-sizing of Balance Sheet means expressing all its items as a percentage all total assets or equities. Similarly, all items of the Income Statement are expressed as a percentage of total sales. The relative proportion of each item is found out as a percentage. If an analysis of financial statements is made after these have been common-sized, it is called Common-size Financial Statement Analysis. The analysis of items is made from top to bottom. So, it is also called a vertical Analysis. Here common-size refers to the proportional relationship in terms of percentage between the total assets, total liabilities, total sales and equities. It is the first step of an enquiry which reveals the differences between comparable items or issues. It shows the areas which require further analysis as regards the causes behind the differences located. Thus it helps to identify any unexpected balance or trend in the financial performance.

Ratios Analysis : It is a ratio between two accounting figures or data expressing the relationship between the two. It is an expression of the relation between different relevant accounting variables. The Financial statements of a business comprise of (1) the Revenue Statement or the Profit & Loss Account and (2) The Balance Sheet. These include a mass of figures which make it difficult to deduce any inference or decision. An accounting ratio is used to gauge the financial solvency and profitability of the business. It is computed from the basic financial statements periodically published by the business and it highlights in arithmetical terms, the relationships that exist between various items from the financial statements.

It is an analytical tool used for financial analysis. It is a process of determination and interpretation, of the numerical relationships between the financial data published by business in periodical statement. It aims at facilitating comparisons with the positions of other business firms as well as of the same business firm over a number of financial periods.

By calculating various liquidity, solvency and profitability ratio, the performance of the company can be measured. Any unexpected or negative trends in these ratio over years will help to detect the fraud in the utilisation of funds, assets, etc.