Financial Statement Fraud: Strategies for Detection and Investigation

CHAPTER SEVENTEEN

Ratio Analysis

IN CHAPTER 16, BASIC FINANCIAL STATEMENT ANALYSIS was introduced in the form of vertical and horizontal analysis. In this chapter, more advanced forms of ratio and data analysis will be explained.

Use of operating ratio analysis is one of the most reliable methods of detecting financial statement fraud. These ratios are most likely to detect fraud when the fraud impacts the numerator and denominator in a proportion that differs from the normal (properly stated) ratio. For example, if the carrying amount of current investments has been overstated as a result of recording fraudulent gains in connection with nonexistent increases in fair value, the entity's current ratio (current assets divided by current liabilities) would be artificially inflated (or an expected deterioration would not occur). Of course, there are numerous other explanations for an improved current ratio, most of which do not involve fraud. But, unexplained changes in key ratios, especially when this occurs with respect to multiple important ratios, should always be investigated, as this may be the first warning sign of a financial reporting fraud.

RESEARCH ON RATIO ANALYSIS

Many books and articles have been written on the subject of ratio analysis as a tool in detecting financial reporting fraud. Most focus on basic horizontal and vertical analysis, or on some of the commonly used financial ratios. Many ratios have the potential for detecting fraud. But which ones actually have ...