This chapter presents the basics of the accounting system, which creates the checks and balances essential to creating financial statements and detecting irregularities within them. The chapter demonstrates how the primary financial statements fit together and how this information can be used to detect problems and highlight where more questions are warranted. With this framework you will have the basic tools to spot the warning signs in a company's financials if there is something amiss.

This chapter examines the framework of relationships between the main financial statements—known to accountants as the articulation of financial statements—and shows the reader how to evaluate the possibility that a company is engaged in accounting games. Due to these interrelationships, a company that overstates its profits on its income statement cannot do so without also overstating its assets or understating its liabilities on the balance sheet. If a company artificially reduces its liabilities to strengthen its perceived financial condition, it will likely need to reduce its assets as well. Should a company artificially inflate its operating cash flow with no corresponding increase in the actual cash balance, it will need to reduce its investing or financing cash flows.

The most common case of fraudulent activity is an overstatement of profits—the first example above. In these cases, an overstatement of assets usually occurs ...

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