Advanced Forensic Financial Analysis

Fraud examiners must hone their financial statement fraud detection methods to overtake the sophisticated crimes of corporate America.  

(This concludes an article that appeared in the September/October issue of The White Paper and is reprinted with permission from the June 2001 issue of National Association of Credit Management's Business Credit magazine.- ed.) 

Corporate fraudsters are committing more devious forms of financial statement fraud by concealing and suppressing the true worth of assets, liabilities, cash flows, sales and profitability. Fraud examiners must stay one step ahead.

Use analytical processes to detect the probability of bankruptcy or fraud:

• Perform a subjective analysis of history and operations of the company. Obtain credit and bank reference information to determine changes in payment habits, relationship with the bank in regards to experience, savings account balances, short- and long-term credit line exposures, and bank compliance.
• Analyze the financial condition by performing a horizontal and vertical analysis of the balance sheet and income statement. The use of industry standard
  statistics is essential in the analytical process, as a means of verifying the condition of ratios and financials in relation to standards.
• Once the conditions of ratios and statistics have been determined, trending analysis is the next step in the analysis process. This process will assist you in detecting inconsistent patterns in the ratios and statistics, which should be regarded as a red flag.
• The detection of trending inconsistencies requires further analysis to determine the factors that impacted the changes in condition of ratios or financial statistics. The detection of imperfections or inaccurate statistics is essential during this analytical process.
• When analyzing the condition and trend of the income statement and balance sheet, it's important to evaluate the gross margin, operating margin, and net profit margin as a percent of sales. This will determine if the changes in condition of the income statement and balance sheet were accordant.
• In-depth knowledge of the balance sheet, income statement, and statement of cash flow requires an understanding of how changes of consistent or inconsistent trending patterns impact the income statement and cash flow.
  Your ability to determine inconsistencies, or unexplainable changes in the income statement and balance sheet will assist you in the beginning stage of forensic financial analysis. Your ability to acquire an investigative perseverance requires an ability to analyze below the surface.

The following reflects some detrimental conditions, which will assist you in determining deteriorating financial conditions and/or detecting financial fraud:

• Have sales increased during a period of decreasing inventory levels?
• Have sales decreased during a period of increasing inventory levels?
• Has inventory valuation impacted the decreasing or increasing of gross profit (GM percent)?
• Is gross profit decreasing during a period of increased sales?
• Is gross profit increasing during a period of decreased sales?
• Does interest expense remain nonexistent during a period of increased or decreased sales?
• Is EBIT/ interest expense less than 1.00?
• Is operating profit negative or decreasing during a period of increased sales?
• Is administrative expense & restructuring charges impacting profitability?
• Is net profit a deficit or down significantly? What factors impacted the condition?
• If the corporate officers have infused cash through an IPO, have liquidity and equity been impacted?
• Has accounts receivable turnover decreased during a period of increased sales?
• Has inventory turnover remained steady or decreased during a period of increased sales?
• Has accounts payable turnover decreased during a period of increased sales?
• During a period of infused cash by corporate officers or an IPO, does debt increase and dept-to-equity remain highly leveraged?
• Does turnover of accounts receivable remain slow - even during a period of increased cash flow?
• Does turnover of accounts payable remain slow - even during a period of increased cash flow?
• Is the debt/equity ratio greater than 4.0? Or does the balance sheet reflect a deficit tangible net worth?

Bringing your level of analysis to a higher level of integrity will maximize your sales capabilities and minimize risk, which will ultimately influence profitability. Accomplishing that level of forensic financial analysis involves completion of the following steps:

Perform a horizontal and vertical trending analysis of the following statistics 

• Income statement and balance sheet
• Ratio analysis
• Trending analysis
• Common-sizing historical statistics by percentages
• Comparative analysis by industry standards
• Cash flow trending analysis

Complete a detailed comparative analysis 

• Evaluate deviations in the financial and ratio statistics.
• Assess the deviations to determine if a correlation exists between the balance sheet and income statements.
• Evaluate the red flags to determine if the condition status has business logic or is unexplainable and a risky condition exists.
• If a risky unexplainable condition exists, evaluate the customer's relationship with the bank pertaining to debt exposure, credit limitations, rate of financing, compliance with credit agreements, and/or amended credit agreements.
• If a risky condition exists, be concerned if there is no banking relationship.
• The use of industry statistics and economic factors must be included in your assessment.
• Assess the history and operations of the company.
• Assess the history of the corporate officers and be concerned about resignations or changes in the company due to bankruptcy or fraud.

The final step involving a more in-depth investigative analytical approach should include comparison of current and historical data with industry statistics, common-sizing historical data by percentages, and the investigation of red flags. Be concerned about comparative ratios or financial results that reflect substantial deviations with condition and trending statistics. Evaluate the combination of liquidity, leverage and profitability ratios to ascertain their pattern of trending consistency or inconsistency. Those committing fraud can manipulate certain statistics to reflect a positive condition, but because of the number of critical ratios, there always will be something left uncovered to distinguish the potential of a cover-up. Utilizing this strategy of recognizing unusual patterns regarding ratios and financial statistics will put you closer to identifying the level of risk and the potential of financial fraud.

Unfortunately, there is no exact science regarding the beginning and ending process of forensic financial analysis. It's your primary objective to investigate the conditions and assess the legitimacy of financial trending information and ratio statistics. There are also no restrictions or limitations regarding the misrepresentation of false statement disclosures of financial statement information.

The following reflects my red flag checklist for assessing financial risk:
During times of increased/decreased sales and profits, changes in trending patterns of accounts receivable, accounts payable, and inventory should exist. Be concerned if the trending patterns remain the same.

• Always be concerned when the financials look too good. Be cautious if they deviate from industry standards.
• Companies in business less than five years have the highest probability of fraud or bankruptcy.
• Be concerned if customer payment habits to you are prompt, and other suppliers reflect slow payment habits.
• Slow payment habits may be an indication of cash flow problems, or weak working capital.
• Analyze the impact of competitive pricing and flexible terms on the Profit and Loss Statement, Statement of Cash Flow, and working capital.
• Are there changes of customer terms, due to competition or cash flow problems?
• Is there any outstanding litigation of suits, liens or judgments?
• Is the background of the management team haunted by past bankruptcies or does it have any skeletons in the closet related to fraudulent activities?
• If a weak cash flow position exists, is it industry or management related?
• Check the current ratio, quick ratio, accounts receivable, and inventory turnover to see if there is correlation between condition and trend.
• If a cash flow problem exists, do they only use suppliers to finance operations, or are they seeking additional financing, recapitalization, or investors for an IPO?
• If new cash comes into the business due to an IPO or recapitalization, keep track of the impact on the balance sheet.
• Monitor changes in the leverage position as a result of a cash infusion due to an IPO or recapitalization.
• Does bank financing exist, or does the company use cash from internally generated funds to finance their operations?
• Monitor the trend of the tangible net worth position to verify deficit conditions, unprofitability, or condition inconsistencies.
• Does slow payment to suppliers continue to exist, even with the infusion of additional cash?
• If the company is highly leveraged, monitor the short- and long-term debt trend and financing rate.
• If bank financing exists, are they remaining in compliance with the financial covenants?

Forensic financial analysis requires an investigative perseverance, which goes beyond evaluating the conditions of financial and ratio statistics. This also includes trend deviations, historical trending analysis, ratio and financial trending analysis, and the evaluation of conditions based on economic and industry statistics. Using this investigative methodology will give you a clearer perspective regarding the reality of condition and trend.

Obviously, in 2002, speculation about worldwide growth is uncertain. Economic and political conditions and competition will impact corporate sales and profitability. Diversifying your analytical knowledge will minimize financial risk and secure your company's short- and long-term growth position. Your ability to look beyond the statistics will bring your department closer to world-class status.

Michael F. Rosplock, CFE, is a senior financial analyst with Corning Incorporated.