1 Financial Statement Analysis: Key to Identifying Fraud Breakout Session # 803 Juanita M. Rendon,...

Financial Statement Analysis: Key to Identifying Fraud

Breakout Session # 803

Juanita M. Rendon, MBA, CPA

April 7, 2009

11:00 AM – 12:30 PM

•Understand general fraud concepts.

•Understand basic financial statements and ratio analysis.

•Understand the usefulness of ratio analysis as a tool in identifying potential fraud.

Learning Objectives

•Fraud •Common Thread in Definitions•Types of Fraud•Fraud Triangle/Fraud Diamond•Incentives To Commit Financial Statement

Fraud•Financial Statement Fraud Issues

•Basic Financial Statements•Standard Setting•Components of Financial Statements

•Ratio Analysis•Categories of Financial Ratios•Ratio Analysis Usefulness as a Tool

Overview

•Fraudulent Activities Cost Billions of Dollars!

•Contracting Managers Need To Be aware Of Potential Fraud.

WHY IS THIS IMPORTANT?

(ACFE, 2008)

ACFE 2008 Report To The NationOn Occupational Fraud and Abuse

Study was based on 959 cases of fraud investigations by CFEs between Jan. 2006 & Feb. 2008

(ACFE, 2008)

ACFE 2008 Report To The NationOn Occupational Fraud and Abuse

Fraud DefinitionDictionary definition:• noun

– deceit; trickery; cheating – LAW: intentional deception to cause a

person to give up property or some lawful right

• a person who deceives, is an impostor or a cheat

http://www.yourdictionary.com/fraud

ACFE Fraud Definition

• Occupational fraud and abuse may be defined as: "The use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization's resources or assets."

(Wells, Joseph T., 2008; ACFE, 2006)

• DOD defines fraud as follows:

– Fraud is any intentional deception taken for the purpose of inducing DOD action or reliance on that deception. Fraud can be perpetrated by DOD personnel—whether civilian or military—or by contractors and their employees.

DOD Fraud Definition

(GAO,2006, June 19, Contract Management: DOD Vulnerabilities to Contracting Fraud, Waste, and Abuse, )

IRS Fraud Definition• Fraud is deception by misrepresentation of

material facts,… resulting in material damage to one who relies on it and has the right to rely on it…

• Tax fraud is often defined as an intentional wrongdoing on the part of a taxpayer, with the specific purpose of evading a tax known or believed to be owing.

Tax fraud requires both: • An underpayment; and• A fraudulent intent.

(Internal Revenue Service, Internal Revenue Manual 25.1.1.2 (05-19-1999))

COMPUTERINTERNET

FRAUD(Cyber Theft)

MORTGAGEFRAUD

(Sub-prime Loans)

HEALTHCAREFRAUD

(Medicare Fraud)

EMPLOYEEFRAUD

(Payroll Fraud)

FINANCIALSTATEMENT

FRAUD (Enron, WorldCom)

CONSUMER FRAUD

(Identity Theft)

TAX FRAUD

(Federal Income Tax)

GOVERNMENTPROCUREMENT

FRAUD(Purchase Cards)

The Fraud Triangle• Criminologist Donald R. Cressey (1919-1987)

– While researching his doctoral dissertation in the 1950s, developed a hypothesis to explain why people commit fraud.

– Published “Other People’s Money: A Study in theSocial Psychology of Embezzlers”

• Dr. Cressey interviewed 200 inmates at prisons in the Midwest

• Three key elements:– Incentive/Motivation/Pressure– Opportunity– Rationalization

(Wells, Joseph T., 2008)

(Wolfe, David T.,& Hermanson, Dana R., 2004, December)

Capability Traits:•Position/Function

•Authority•Influence

•Brains•Knowledge

•Coercion Skills•Confidence/ego•Effective Lying

Fraudulent

Financial

Statement

Issues

FictitiousRevenue/Accounts

Receivable

Inventory/Cost of Goods Sold

Timing Or

Classification

Issues

Disclosure/Lack Of

Transparency

UnderstatedLiabilities/Expenses

OverstatedAssets/Income

ImproperAsset

Valuation

Most businesses prepare :

1. Income Statement

2. Balance Sheet

3. Statement of Cash Flows

4. Statement of Stockholders’ Equity

5. Statement of Retained Earnings

Overview of Financial StatementsOverview of Financial StatementsOverview of Financial StatementsOverview of Financial Statements

In the U. S., financial statements are based onIn the U. S., financial statements are based onGenerally Accepted Accounting Principles (GAAP).Generally Accepted Accounting Principles (GAAP). (Albright & Ingram, 2006)

The Securities and The Securities and Exchange Commission Exchange Commission (SEC) and the Public (SEC) and the Public Company Accounting Company Accounting Oversight Board Oversight Board (PCAOB) oversee the (PCAOB) oversee the publically tradedpublically traded companies.companies.

The Financial The Financial Accounting Standards Accounting Standards Board (FASB) Board (FASB) (American Institute of (American Institute of Certified Public Certified Public Accountants -- Accountants -- AICPA) oversees the AICPA) oversees the privateprivate companies.companies.

Standard Setting OrganizationsStandard Setting OrganizationsStandard Setting OrganizationsStandard Setting Organizations

(Albright & Ingram, 2006)

The Governmental Accounting Standards Board (GASB) sets accounting standards for state & local governments

The U. S. Government Accountability Office (GAO) oversees accounting in the federal government.

Standard Setting OrganizationsStandard Setting OrganizationsStandard Setting OrganizationsStandard Setting Organizations

The International Accounting Standards Board (IASB) is an independent, privately-funded board interested in global accounting standards (International Financial Reporting Standards).

Sources of Accounting RegulationsSources of Accounting RegulationsSources of Accounting RegulationsSources of Accounting Regulations

The Sarbanes-Oxley Act (SOX) was passed by Congress in 2002. This act affected the responsibilities of auditors, boards of directors, and corporate managers with respect to financial reporting. The primary purpose was to increase investor confidence.

Auditing standards include procedures used in conducting an audit to help

auditors form an opinion about the fairness of the audited statements. (GAAS:

Generally Accepted Auditing Standards). For the federal government, the Generally Accepted Government Auditing Standards

(GAGAS) are used.

Auditing standards include procedures used in conducting an audit to help

auditors form an opinion about the fairness of the audited statements. (GAAS:

Generally Accepted Auditing Standards). For the federal government, the Generally Accepted Government Auditing Standards

(GAGAS) are used.

The Auditors’ The Auditors’ ReportReportThe Auditors’ The Auditors’ ReportReport

(Albright & Ingram, 2006)21

The Income Statement (Statement of Earnings) reports revenues and expenses for an accounting period.

ABC Company, Inc.Income Statement

For the Year Ended December 31, 2008Sales revenue $700,500Cost of goods sold (450,200)Gross profit 250,300

Depreciation Expense (60,000) Selling, general, & administrative exp. (90,300) Operating income 100,000

Interest expense (5,000)Pretax income 95,000Income taxes (40% tax rate) (38,000)Net income $ 57,000

A Balance Sheet (Statement of Financial Condition) identifies a company’s assets and claims to those assets by creditors and owners at a specific date.(A = L + SE) (a snapshot)

ABC Company, Inc.Balance Sheet

At December 31, 2008AssetsCurrent assets:

Cash $ 12,600Accounts receivable 9,600Merchandise inventory 22,000Supplies 800Prepaid rent 1,000

Total Current Assets $ 46,000Long-term (Fixed) Assets:Property and equipment, at cost 300,000

Less Accumulated depreciation (60,000)Total Long-term (Fixed) Assets $240,000Total Assets $286,000

ContinuedContinuedContinuedContinued

Liabilities and Stockholders’ Equity:Current Liabilities:

Accounts payable $ 8,500Unearned revenue 3,800Interest payable 700Notes payable, current portion 4,000

Total Current Liabilities $ 17,000Long-term liabilities:Notes payable, long-term 80,000Total Liabilities $ 97,000Stockholders’ equity:

Common stock 150,000Retained earnings 39,000

Total Stockholders’ Equity $189,000Total Liabilities and Stockholders’ Equity $286,000

ABC Company, Inc.Balance Sheet

At December 31, 2008

Assets:Total assets $286,000

Liabilities and Stockholders’ Equity

Total Liabilities and Stockholders’ Equity $286,000

Must Equal

AssetsAssets = LiabilitiesLiabilitiesStock-holders’ Equity

Stock-holders’ Equity

The Financial Obligations or Debts of a Business

The Basic Accounting EquationThe Basic Accounting EquationThe Basic Accounting EquationThe Basic Accounting Equation

Economic Resources Owned by a Business

Owners’ Claims on the Assets of a Business

The Statement of Cash Flows reports events that affected a company’s cash account during a fiscal period; has three sections: operating, investing, & financing.

The The StatementStatement of Cash Flows of Cash FlowsThe The StatementStatement of Cash Flows of Cash Flows

Investing activities involve the buying and selling of long-term assets.

Financing activities involve transactions between a company and its owners or creditors.

Operating activities involve the buying or producing and the sale & distribution of goods and

services to customers related to cash.

Operating activities involve the buying or producing and the sale & distribution of goods and

services to customers related to cash.

The Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash FlowsThe Statement of Cash Flows

GAAP permits the statement to be presented in either of two formats: direct or indirect.GAAP permits the statement to be presented in either of two formats: direct or indirect.

GAAP requires a schedule to reconcile cash flows from operating activities with net income if the direct format is used.

The differences between formats are in the operating section only. 99% of companies use the indirect method.

ABC Company, Inc.Statement of Cash Flows

For the Year Ended December 31, 2008

Operating ActivitiesNet income $ 57,000Depreciation exp. (noncash) 60,000Increase in accounts receivable (CA) (20,000)Increase in merchandise inventory (CA) (32,000)Increase in supplies (CA) (1,200)Increase in prepaid rent (CA) (5,000)Increase in accounts payable (CL) 6,600Increase in unearned revenue (CL) 3,000Increase in interest payable (CL) 400

Net cash flow from operating activities $ 68,800

From the income statement

Indirect

Carried forward $ 68,800Investing Activities

Payments for purchase of equipment (231,700)Receipts from sale of equipment 500

Net cash flow for investing activities (231,200)Financing Activities

Receipts from sale of common stock 150,000Payment of dividends (20,000)Receipts from borrowing 60,000Repayment of debt (15,000)

Net cash flow from financing activities 175,000Net increase in cash 12,600Cash balance, December 31, 2007 0Cash balance, December 31, 2008 $ 12,600

Statement of Stockholders’ Equity CC RE TotalBalance at Jan. 1, 2008 $ 0 $ 2,000 $ 2,000+ Common Stock Issued 150,000 150,000+ Net Income 57,000 57,000- Dividends ______ <20,000> <20,000>= Balance at Dec.31, 2008 $150,000 $39,000 $ 189,000

This statement links the income statementto the balance sheet. It describes how much Net Income was reinvested as part of RE.

Statement of Stockholders’ EquityStatement of Stockholders’ EquityStatement of Stockholders’ EquityStatement of Stockholders’ Equity

ABC Company, Inc.Statement of Retained Earnings

For the Year Ended December 31, 2008

• Retained Earnings, Jan. 1, 2008 $ 2,000• Net income for 2008 57,000• Less: Dividends (Pmt. to Stkhldrs) (20,000) 37,000• Retained Earnings, Dec. 31, 2008

$39,000This shows the amount of Net earnings (NI) retained by the company and the dividendsdistributed to shareholders. RE is part of the B/S.

Statement of Retained Earnings Statement of Retained Earnings Statement of Retained Earnings Statement of Retained Earnings

Title of SlideIncome Statement:

Revenues

= Net Income or

(Net Loss)

Balance Sheet:

Assets

Liabilities

Stockholders’ Equity: *Capital Stock

*Retained Earnings

A = L + SE

• Vertical Analysis: involves measuring relationships between items for a single year. For example, % of sales on an income statement; % of total assets & % of total Liabilities & Stockholders’ Equity on a balance sheet

• Horizontal Analysis: involves calculating the Dollar change and the Percent change for each line item on the Income Statement or Balance Sheet from the previous year to the current year.Current year – Previous year/Previous year x 100 = % change

• Ratio Analysis: Various ratios

Financial Statement Analysis MethodsFinancial Statement Analysis MethodsFinancial Statement Analysis MethodsFinancial Statement Analysis Methods

(Brigham & Houston, 2007)

Why are ratios useful?• Ratios can standardize numbers and

facilitate comparisons.• Ratios can be used to highlight

weaknesses and strengths.• Ratio comparisons should be over a

period of time and with competitors in the same industry– Trend analysis– Industry analysis

• Liquidity (Solvency): Can the company meet its short-term obligations?

• Asset management (Operating Efficiency): Is the company using its assets to generate sales?

• Debt Management: Does the company have the right mix of debt and equity? Is the company highly leveraged?

• Profitability: Is the company consistently making a profit? Is the company managing its expenses?

• Market Value: Do investors like what they see?

Five Major Categories Of RatiosFive Major Categories Of Ratios

SUMMARY OF RATIOS

Liquidity Asset Management Debt Management Profitability Market Value

Current Ratio (Current Assets/Current

Liabilities)

Accounts Receivable Turnover

(Net Sales/Net Accounts Receivable)

Debt/Equity (Debt Ratio)

(Total Liabilities/Total Stockholders' Equity

Gross Profit Margin(Gross Profit/Sales)

Earnings Per Share (EPS) (Net Earnings/Average

Shares Outstanding)

Quick Ratio (CA-Inventory/CL)

Inventory Turnover (Sales/Inventories)

Debt/Assets (Total Liabilities/Total

Assets)Operating Profit Margin (Operating Profit/Sales)

Price/ Earnings (PE) (Market Price of Common

Stock/EPS)

Cash Flow Liquidity Ratio Cash Flow From Operating

Activities/Total Assets)Fixed Asset Turnover (Sales/Fixed Assets)

Times Interest Earned (EBIT/Interest Expense)

Net Profit Margin (Net Profit/Sales)

Dividend Payout (Cash Dividends Per

Share/EPS)

Days Sales Outstanding (DSO) or Average Collection Period

(AR/Average Sales Per Day)Total Asset Turnover (Sales/Total Assets)

Return on Assets (ROA) (Net Income/Total Assets)

Dividend Yield (Cash Dividends Per

Share/Market Price of Common Stock Per Share)

Return on Equity (ROE) (Net Income/Total

Stockholders' Equity)

Prepared by Juanita M. Rendon, CPA

CashAccts. ReceivableInventories Total Current AssetsGross L-T AssetsLess: Acc. Depreciation

Net L-T AssetsTotal Assets

20078,000

630,0001,300,0001,938,0001,300,900

- 400,000 900,900

2,838,900

2008100,800 900,800

2,148,8003,150,4001,800,000

- 899,400 900,600

4,051,000

TYL, Inc.: Balance SheetTYL, Inc.: Balance SheetTYL, Inc.: Balance SheetTYL, Inc.: Balance Sheet

Liabilities and Equity:Accts. payableNotes payable, currentUnearned Revenue

Total Current Liab.Long-term debt

Total Liabilities:Stockholders’ Equity:Common stockRetained earnings

Total Stkhldrs EquityTotal Liab. & Equity

2007530,100

600,800 490,0001,620,900

800,0002,420,900

387,500 30,500

418,0002,838,900

2008430,700

250,000 450,0001,130,700

500,0001,630,700

2,084,574 335,7262,420,300

4,051,000

(Brigham & Houston, 2007)42

SalesCOGS Gross Profit (GM)Other expenses

EBITDADepr. & Amort.EBITInterest Exp.Earnings Before TaxesTaxes (40% tax rate)Net income

20074,500,000(3,500,000) 1,000,000 ( 500,900) 499,100 ( 100,900) 398,200 ( 130,000) 268,200 (107,280) 160,920

20087,000,600

(5,800,990)

1,199,610 (500,000)

699,610 (110,900)

588,710 ( 80,000)

508,710 ( 203,484) 305,226(Brigham & Houston, 2007)

TYL, Inc.: TYL, Inc.: Income StatementTYL, Inc.: TYL, Inc.: Income Statement

No. of sharesEPSStock price

2008150,000

$2.035$12.57

2007100,000

$1.609$8.85

TYL, Inc.: TYL, Inc.: Other dataTYL, Inc.: TYL, Inc.: Other data

TYL Inc.’s forecasted current ratio and quick ratio for 2008:

Current ratio = Current assets / Current liabilities= $3,150,400 / $1,130,700= 2.79x

Quick ratio = (CA – Inventories) / CL= ($3,150,400 – $2,148,800) / $1,130,700

= 1,001,600/1,130,700= 0.89x

Financial Analysis: Liquidity RatiosFinancial Analysis: Liquidity RatiosFinancial Analysis: Liquidity RatiosFinancial Analysis: Liquidity Ratios

(Brigham & Houston, 2007;Fraser & Ormiston, 2010)

Comments on liquidity ratios2008 2007 2006 Industry

Current Ratio 2.79x 1.20x 2.32x 3.98x

Quick Ratio 0.89x 0.39x 0.86x 1.12x

• Measure short-run solvency—the ability of a co. to meet its short-term debt requirements as they come due.

• For 2008, Co. had $2.79 of CA for $1 of CL; For 2008, Co. has $ .89 of cash & near cash assets for every $1 of CL.

• Below industry average; Liquidity position is weak.• The higher the liquidity ratios, the better.

Financial Analysis: Liquidity RatiosFinancial Analysis: Liquidity RatiosFinancial Analysis: Liquidity RatiosFinancial Analysis: Liquidity Ratios

(Brigham & Houston, 2007;Fraser & Ormiston, 2010)

The inventory turnover vs. the industry average: (2008)

Inv. turnover = Sales / Inventories=

$7,000,600/$2,148,800= 3.26x = 3.3x

Financial Analysis: Asset Management RatiosFinancial Analysis: Asset Management RatiosFinancial Analysis: Asset Management RatiosFinancial Analysis: Asset Management Ratios

What is the inventory turnover vs. the industry average?

2008 2007 2006 Industry

Inventory

Turnover3.3x 3.5x 4.9x 6.2x

• Indicates the number of times a company sells its average inventory level during the year.

• Inventory turnover is below industry average.• The company might have old inventory, or its control might

be poor. • A higher inventory turnover is usually better.

(Days Sales Outstanding) DSO is the average number of days after making a sale before receiving cash. (2008)

DSO = Accounts Receivable / Avg sales per day

= Accounts Receivable / (Annual sales/365)

= $900,800 / ($7,000,600/365)

= $900,800/19,179.73

= 47.0 days

Analysis of Days Sales Outstanding

2008 2007 2006 Industry

DSO 47.0 51.1 36.3 31.2

• Measures the number of days between the sale date and the cash collection date.

• The company is below industry average; it collects on sales on account (A/R) too slowly

• It appears to have a poor credit policy.• A lower DSO is usually better.

sales current year

Sales Growth Index = _____________

sales prior year

Fixed assets (FA) and total assets (TA) turnover ratios vs. the industry average (2008)

FA turnover = Sales / Net fixed assets

= $7,000,600/$900,600 = 7.8x

TA turnover = Sales / Total assets

= $7,000,600/$4,051,000 = 1.7x

Evaluating the Fixed (Long-term) Asset Turnover and Total Asset Turnover Ratios:

2008 2007 2006 Industry

FA TO 7.8x 5.0x 11.0x 8.1x

TA TO 1.7x 1.6x 2.5x 3.7x

• Measure efficiency; Show how many sales $ a co. can generate from each $1 of its assets.

• In 2008, FA turnover is below the industry avg.• TA turnover is below the industry average. May be

caused by excessive currents assets (A/R and Inventory).

The debt ratio (D/A) and times-interest-earned (TIE) ratios. (2008)

Debt ratio = Total debt / Total assets= ($1,130,700 + $500,000/$4,051,000

= 1,630,700/4,051,000 = 40.3%

TIE = EBIT / Interest expense

= $588,710/$80,000 = 7.4x

Financial Analysis: Debt Management RatiosFinancial Analysis: Debt Management RatiosFinancial Analysis: Debt Management RatiosFinancial Analysis: Debt Management Ratios

How do the debt management ratios compare with industry?

2008 2007 2006 Industry

D/A 40.3% 85.3% 54.7% 30.2%

TIE 7.4x 3.1x 4.2x 9.1x

• Debt to Asset Ratio (debt ratio) shows the % of each $1 of assets that is financed with debt.

• Times Interest Earned (TIE) ratio measures a company’s ability to pay the interest on its debt. For 2008, the co. has available $7.40 of earnings before interest and taxes for each $1 of interest it must pay to its creditors.

How do the debt management ratios compare with industry?

2008 2007 2006 Industry

D/A 40.3% 85.3% 54.7% 30.2%

TIE 7.4x 3.1x 4.2x 9.1x

• D/A and TIE for 2008 are worse than the industry average, • A lower debt ratio (D/A) is usually better.• A higher TIE is better.

Profitability ratios: Net Profit margin (NPM) (2008)

Net Profit margin= Net income / Sales

= $305,226/$7,000,600 = 4.4%

Financial Analysis: Profitability RatiosFinancial Analysis: Profitability RatiosFinancial Analysis: Profitability RatiosFinancial Analysis: Profitability Ratios

Analyzing profitability with the net profit margin

2008 2007 2006 Industry

NPM 4.4% 3.6% 2.5% 3.8%

• NPM represents the company’s ability to translate sales dollars into profits; a higher NPM is better.

• Net Profit margin was below the industry average in 2006 and 2007, but is exceeded the industry average in 2008.

Profitability ratios: Return on assets and Return on equity

(2008)

ROA = Net income / Total assets

= $305,226/$4,501,000 = 7.5%

ROE = Net income / Total Stkhlders equity

= $305,226 / $2,420,300 = 12.6%

Analyzing profitability with the return on assets & return on equity

2008 2007 2006 Industry

ROA 7.5% 5.7% 6.3% 9.3%

ROE 12.6% 38.5% 13.2% 18.4%

• ROA shows how much profit a co. is able to earn from each $1 of its assets. For 2008, the co. is earning 7.5 cents for each $1 of assets.

• ROE shows how many cents are earned on each $1 of stockholders’ investment. For 2008, the co. is earning 12.6 cents for each $1 of its owners’ investment (equity).

• Both ratios are below the industry average.

Analysis of Sales Growth Index2008 2007 2006 Manipulator &

Non-Manipulator

SGI 1.556 1.611 1.534 1.607/1.134

(Harrington, 2005; Beneish, 1999)

Sales Current Year

Sales Growth Index = _____________

Sales Prior Year

7,000,600

2008 Sales Growth Index = ___________ = 1.556

4,500,000

Analysis of Gross Margin Index2008 2007 2006 Manipulator

& Non-Manipulator

GMI 1.297 1.311 1.233 1.193/1.014

Gross Margin prior year/sales prior year

Gross Margin Index = _____________________________

Gross Margin current year/sales current year

(1,000,000/4,500,000)

2008 Gross Margin Index = ____________________

(1,199,610/7,000,600)

2008 Gross Margin Index = ____________________ = 1.297

Analysis of Days’ Sales in Receivables Index2008 2007 2006 Manipulator

&Non-Manipulator

DSRI .919 .998 1.033 1.465/1.031

Receivables Current Year/ Sales Current Year

Days' Sales in Receivables Index = ________________________________

Receivables Prior Year/Sales Prior Year

900,800/7,000,600

2008 Days' Sales in Receivables Index = _________________

630,000/4,500,000

2008 Days' Sales in Receivables Index = ________ = .9193

Analysis of Asset Quality Index2008 2007 2006 Manipulator

&Non-Manipulator

AQI 1.000 1.344 1.256 1.254/1.039

Asset Quality Index = (1 – [(CA + Net FA)/Total Assets] Current Year) (1- [(CA + Net FA)/Total Assets] Prior Year)

Asset Quality Index = (1 – [(3,150,400 + 900,600)/4,051,000] (1-[(1,938,000 + 900,900/2,838,900]

Asset Quality Index = (1 – [4,051,000/4,051,000] = 1.000 (1-[2,838,900/2,838,900]

(Wells, August 2001; Beneish, 1999)

Example of Financial Statement Fraud

Non-manipulators’ mean: 1.134Manipulators’ mean: 1.607 and above

Sales Growth Index = Current Period Sales/Prior Period Sales

Non-manipulators’ mean: 1.039Manipulators’ mean: 1.254 and above

Asset Quality Index = (1 – CA + Net FA/Total Assets Current Year) (1-CA + Net FA/Total Assets Prior Year)

Usefulness of Financial Ratio Analysis:

• Quickly evaluate a company’s financial position & profitability.

• Used for trend analysis within a company over a period of years.

• Can compare the financial strength of different companies.

(Williams, Haka, Bettner, & Carcello, 2008)

Qualitative Factors in Financial Statement Analysis

RegulatoryEnvironment

Competition

Revenues Tied To One Key Customer, Product,

Or Supplier

Legal Environment

Future Prospects

Qualitative Factors

Limitations of Financial Statement Ratio Analysis

Analysts should look beyond the ratios.

Economic Factors

Industry Trends;

Seasonal

Different Accounting Practices

Technological Changes

Inappropriate Industry

Comparisons

Limitations of FS Ratio Analysis

Limitations of Financial Statements

Analysts should research company & industry.

Use of Estimates

Delay in providing

information

Omission of resources &

Use of Historical Costs

Omission of Transactions

Limitations of FS

Efforts to Prevent & Detect Fraud

• ACFE Educational Anti-fraud Resources

• AICPA Antifraud & Corporate Responsibility Center

• Sarbanes Oxley Act of 2002

Free Information Sources

• SEC Edgar Databasehttp://www.sec.gov/search/search.htm• Yahoo Financehttp://finance.yahoo.com/• Company Websites• http://www.bizstats.com/

•Fraud •Common Thread in Definitions•Types of Fraud•Fraud Triangle/Fraud Diamond•Incentives To Commit Financial Statement

Fraud•Financial Statement Fraud Issues

•Basic Financial Statements•Standard Setting•Components of Financial Statements

•Ratio Analysis•Categories of Financial Ratios•Ratio Analysis Usefulness as a Tool

Summary

THANK YOU FOR YOUR ATTENTION!

CONTACT E-MAIL:

jmrendon@nps.edu

QUESTIONS?

ReferencesAlbright, T. L., & Ingram, R. W. (2006). Financial accounting: A bridge to

decision-making. 6th Edition. Mason, OH: Thomson South-Western.

ACFE 2008 Report to the Nation on Occupational Fraud and Abuse. (2008)

Beneish, M. D. (1999, September/October). The detection of earnings manipulation. Financial Analyst Journal. 55(5), 24-36.

Brigham, E. F., & Houston, J. F. (2007). Fundamentals of financial management. 5th Edition. Mason, OH: Thomson South-Western.

Fraser L. M. & Ormiston, A. (2010). Understanding Financial Statements, 9th Edition. New York, NY: Prentice Hall

Fraud definition. (n.d.) Retrieved from http://www.yourdictionary.com/fraud

References (continued)Fraud Definition. Internal Revenue Service. Internal Revenue Manual §

25.1.1.2 (05-19-1999) Retrieved from http://www.irs.gov/irm/part25/ch01s01.html#d0e43

GAO. (2006, June 19).Contract Management: DOD Vulnerabilities to Contracting Fraud, Waste, and Abuse. GAO Code 120518/GAO-06-838R.

Harrington, C. (2005, March/April). Formulas for detection: Analysis ratios for detecting financial statement fraud. Fraud Magazine. Association of Certified Fraud Examiners. Retreived January 15, 2009, from http://www.acfe.com/resources/view-content.asp?ArticleID=416

Rosplock, M. F. (2001, June). Advanced analytical techniques for performing forensic financial analysis. Business Credit. 103(6), 26-31.

References (continued)

Well, Joseph T. (2008). Principles of Fraud Examination. 2nd Edition. Hobken, NJ: John Wiley & Sons, Inc.

Wells, J. T. (2001, August). Irrational Ratios. Journal of Accountancy. 192(2), 80-83.

Williams, J. R., Haka, S. F., Bettner, M. S., & Carcello, J. V. (2008). Financial & managerial accounting: The basis for business decisions. 14th Edition. New York, NY: McGraw-Hill/Irwin.

Wolf D. T. & Hermanson, D. R. (2004, December). The fraud diamond: Considering the four elements of fraud. The CPA Journal. 38-42.

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