Use this simple tool to discover anomalies on both sides of the balance sheet.
The common-size diagram – a basic tool for financial statement analysis and fraud detection – is a simple, visual way to order, draw, and discuss a balance sheet. The diagram can recognize the relative risk on the asset side of the balance sheet and highlight assets that appear too large by industry standards. It can pinpoint assets that have grown out of proportion and demonstrate the general tendency of financing along with the assets financed.
The diagram also can show the creditor claims against assets and help visualize tangible net worth. It is a terrific tool for discovering which creditor is financing losses and for demonstrating the effects of a balance sheet restructure, which is a common event in today’s economy. And beyond that, the common-size diagram is an important training instrument to help generate recognition exercises and develop expectations for fraud examiners.
The diagram’s origins are unknown but common-size analysis has been prevalent in financial-statement analysis for years. Various forms of balance-sheet diagrams have appeared in financial analysis publications and the visual process of presenting the balance sheet is common in bank training programs.
A fraud examiner should have a set of expectations prior to analyzing the target company’s financial statements. For example, a manufacturer should have a bit more invested in Inventory than Accounts Receivable due to the lead times in manufacturing and the investment in raw material, work-in-process, and finished goods. And a manufacturer should have a fairly large investment in Net Fixed Assets.
Expectations of a “clean balance sheet” would exclude large investments in Due from Affiliates or Other Assets. Large investments in Due from Affiliates on the common-size diagram are a lightning rod for further research and investigation. In certain industry sectors, expectations of a clean balance sheet also would exclude material investments in Goodwill or other Intangibles.
Fraud examiners cannot expect to be experts in every industry sector. However, they can develop expectations of accounting characteristics for not only manufacturers of goods and services but also brokers and distributors.