Fraud Detection

1
Fraud Detection

• Through Financial Statement Analysis

2
What Causes Misstatements

• Financial statement misstatements arise primarily
  from
• Lack of competence or diligence of accounting
  personnel
• Poor internal controls
• Financial Statement Fraud
• Misappropriation of Assets

3
Why is FS Fraud Committed?

• To meet company goals and objectives
• To receive performance-related bonuses
• To obtain financing (or to obtain better terms on
  financing)
• To show compliance with covenants
• To dispel negative market perceptions
• To encourage investment in securities

4
An Approach to Fraud Deterrence

• Make everyone aware of fraud signs
• Establish specific responsibilities for each
  position within the entity
• Set up and monitor internal controls
• Investigate unusual suspicious signs
• Begin formal fraud investigations only when signs
  of fraud are found

5
Risk Factors Relating to Fraudulent Financial
Reporting

• Managements characteristics and influence over
  the control environment
• Industry conditions
• Operating characteristics and financial stability
• Source SAS 82

6
Risk Factors Relating to Misappropriation of
Assets

• Susceptibility of assets to misappropriation
• Controls
• Source SAS 82

7
Financial Statement Fraud

• Definition
• Intentional misrepresentations on financial
  statements intended to deceive the users of the
  financial statements.
• Misrepresentations may be caused by
• Intentional misapplication of GAAP
• Alteration of financial records or supporting
  documentation
• Omission of significant information

8
Fraud Signs follow risk factors

• Unbelievable performance
• Unusual ratios
• Unexplained changes
• Overly aggressive management
• Highly centralized power structure
• Poor internal controls

9
Financial Statement Analysis

• Analyzing financial statements for signs of fraud

10
Financial Statement Analysis

• Examining relationships and trends on financial
  statements to
• Evaluate past performance
• Develop expectations of future results
• Detect misstatements

11
Basic Financial Statements

• Balance Sheet
• Shows assets (things owned), liabilities (debts
  owed), and equities (the owners investment)
• Income Statement
• Shows revenues, expenses, and profits
• Statement of Cash Flows
• Where the cash came from and where it went
• Statement of Owners Equity
• Summary of the investment made by the owners

12
Vertical Analysis

• Also called Common-Size Financial Statements
• Examines relationships between accounts
• Balance sheet
• Each line is expressed as of total assets
• May be expressed as of sales
• Income Statement
• Each line expressed as of sales

13
Horizontal Analysis

• Observation of trends over time
• Compute changes from year to year
• Expressed as difference in dollars
• Expressed as percentage change

14
Ratio Analysis

• Examines relationships between accounts
• Compared against similar organizations
• Compared against expectations
• Reveals
• Strengths and weaknesses
• Causes for concern

15
Liquidity Ratios

• Current ratio
• current assets (ca)/current liabilities (cl)
• Quick or Acid Test ratio
• (ca inventory)/cl

16
Leverage Ratios

• Debt to total assets
• total liabilities/total assets
• Debt to equity
• total liabilities/stockholders equity

17
Profitability Ratios

• Return on sales
• net income/sales
• Return on assets
• net income/total assets
• Return on equity
• net income/stockholders equity