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.

Developing Expectations

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.

Drawing the Common-size Diagram

The fraud examiner can generate the diagram on any spreadsheet program but we will use Microsoft Excel. (We will create the diagram in Excel’s manual format because the applications chart wizard will prevent automatic updates when we change the balance sheet data.) First, name and create a dedicated Excel worksheet. Using the Borders button in the Formatting toolbar, outline six columns and 40 rows. I usually start with Column B, allowing Column A as a margin. Next, run the same thick line border over three columns and forty rows, splitting your rectangle in half. (Your diagram should look similar to the one at the right.)

[Diagram 1 is no longer available. — Ed.]

The left side of the diagram will represent Assets, while the right side of the balance sheet will represent Liabilities and shareholders’ Equity. Next, label the total Assets (in dollars or the applicable currency in use) under the diagram, on the left-hand side. Label the total Liabilities plus shareholders’ Equity under the diagram on the right-hand side. Now calculate the value of each cell in the diagram by dividing total Assets ($20 million in this case) by 40. In our example, the value per cell would equal $500,000.

Because this is simply a tool to indicate possible irregularities, we are not bound to U.S. GAAP or any other international accounting principles. However, we should use a critical path to decide how to portray the Assets first. I run the productive Assets in liquidity order but place all of the indirect Assets at the bottom of the diagram. In other words, I portray Cash (including marketable securities), Accounts Receivable, Inventory, and Net Fixed Assets from top to bottom, and I portray Other Assets (including prepaid assets and goodwill), at the bottom of the diagram.

I now consult my subject balance sheet and find that Cash (including marketable securities) is valued at $1 million. I use the same thick line border button and draw two cells on the left side ($1 million/$500,000 = 2) and label the drawing as Cash. Follow the same procedure for each asset: divide the balance sheet value by $500,000 and determine the number of cells to draw. Our diagram should now look like Diagram 1. (Please note: For space reasons, the diagrams do not contain all the cells found on the orginal Excel documents.)

Notice the investment in Accounts Receivable that is much larger than Inventory. Is this a seasonal aberration or is this representative of an out-of-season slow turn that requires your investigation? This should prompt the fraud examiner to test revenue recognition procedures, billing and collecting procedures, and aging and reporting procedures for Accounts Receivable.

We are curious to see how the Equity drawing is going to match up against Other Assets. If the Equity portion of the balance sheet does not cover the entire investment in Other Assets ,we have tangible negative net worth. If the Equity portion of the balance sheet more than covers Other Assets, we have tangible positive net worth.

Let us draw Equity at the bottom of the right-hand column and see how it matches up to Other Assets. The value on our subject balance sheet indicates $2.5 million in shareholders’ Equity. That would represent five cells in our diagram ($2,500,000/ $500,000). The resulting shareholders’ Equity is short of covering the Other Assets by $500,000. In other words, our subject company has a negative tangible net worth of $500,000.

Now that we can view the asset structure and recognize that Equity does not cover the entire risk in Other Assets, we understand the potential impact to other stakeholders for any potential write-down in Inventory or Other Assets. If we study the remaining stakeholders in liquidity order, we can isolate who is taking that risk.

Again, we do not need to follow GAAP conventions. The right-hand side of the balance sheet should be drawn in liquidity order for a “going concern.” If you were to analyze a balance sheet for a potential restructure or liquidation, the right-hand side should be drawn in order of priority of Asset claims. In other words, in a restructure the senior secured Debt would be at the top. Junior secured Debt would follow and unsecured Debt would land just above Equity. Always combine the current portion of Long-term Debt with past Long-term Debt for a total debt picture.

We will try to portray a corporate financing objective called “tenor matching” (or matching for the general tendency) for the “going concern” presentation. The idea is that Short-term Assets should be funded by Short-term Debt and Long-term Assets should be funded by Long-term Debt. This tenor matching optimizes the liquidity of the corporation.

Finally, we will portray the Accrued Expenses under Accounts Payable and be concerned any time the Accrued Expenses reaches or surpasses the value of Accounts Payable. Why? Accrued Expenses is one of the miscellaneous dumping grounds of the balance sheet. It is a convenient place to park customer deposits, past due taxes, and other past due liabilities. Accrued Expenses should be made up of unpaid payroll, associated payroll taxes, unpaid vacation, and unpaid commissions. Values in excess of 30 days on hand for Accrued Expenses should be suspect for unrelated items.

Drawing the right-hand side of our diagram should produce Diagram 2, left.

[Diagram 2 is no longer available. — Ed.]

We have several observations to make. First, Long-term Debt is financing the risk in Other Assets not covered by shareholders’ Equity. Long-term Debt is also providing some of the funding for Inventory, a short-term asset, hence some level of tenor mismatch. Accrued Expenses are twice as large as Accounts Payable, indicating a need for further investigation into the sources of value for the Accrued Expenses. The Accounts Payable value is so small, one would want to investigate the status of current trade terms. What do the unsecured creditors know that I do not know? After all, they may very well be just another segment of the same industry sector and have strong industry-related knowledge.

Notice the large funding provided by Short-term Debt. Clearly, this is the largest stakeholder in our balance sheet and not at all uncommon in middle-market companies that make up a huge portion of our economy. A bank or large commercial finance company more than likely provided this Short-term Debt. In the U.S. it can represent revolving debt as “structured finance,” “cash flow lending,” or “asset based finance.” In the U.K. and many other parts of the world this same Short-term Debt is represented by the bank overdraft facility.

While the Long-term Debt player is taking risk in the potential write-down of Other Assets, the Short-term Debt player is taking risk in the potential write-down of Inventory. Find out if the Short-term Debt player is the senior secured lender. If so, the Short-term Debt player will have a claim to the Cash, Accounts Receivable, and Inventory of the subject company.

If the Long-term Debt player is a separate lender, there will be an inter-creditor agreement between the two lenders to establish the rights of the Long-term Debt player to the Long-term Assets. Be careful that the senior secured Short-term Debt player will not relinquish claims to the intangible assets on an ordinary basis. This means that the market value of those Net Fixed Assets had better be higher than historical cost for the long-term lender to get out whole in a liquidation.

So we have demonstrated how to draw a diagram and we have also started analyzing and interpreting. We isolated two assets that are suspect to fraud – Inventory, and Other Assets. We isolated two liabilities that are subject to fraud, Accounts Payable and Accrued Expenses. We highlighted the stakeholders who are currently funding those potential risks, the Short-term and Long-term Debt players. Hmmmmmmmmm... All that in a company with tangible negative net worth and high financial leverage. Certainly these are financial anomalies for any fraud profile. One common title for the next step is: “The Search for the Dead Debits.”

An early example of using the common-size diagram to detect a fraud was generated from a financial institution engagement. A local bank had a $3 million short-term debt position in a small consumer product distributor that had recently completed an initial public offering. The bank had taken Accounts Receivable and Inventory as collateral for their loan and had required annual audits by a reputable public accounting firm. A recent fiscal year-end audit was also required for the IPO.

The subject’s balance sheet was drawn as shown in Diagram 3 right.

[Diagram 3 is no longer available. — Ed.]

The “due from affiliates” stood out like a sore thumb. A review of the general journal indicated that there was one entry for $23 million at the end of the last fiscal quarter, a classic sign for further investigation. The entry turned out to credit inventory and debit “due from affiliates.” It was a sham transaction. The company had indeed lost all $23 million in a poor purchase of inventory that was highly speculative. Rather than face the losses just before the IPO, they elected to hide the losses in the “due from affiliates” and move forward with the IPO. After reporting to the local bank, they initiated default procedures and liquidated their secured loan position.

Risk Profiles Using Common-size Diagrams

Now that we have interpreted one “risky business” balance sheet, what should balance sheets for a broker, distributor, or manufacturer look like? What are the associated risks for all three?

A broker of product or services is a business that acts as an agent that never takes possession of the goods or services. In other words, brokers usually take a commission for matching buyers and sellers. The goods are almost always “drop shipped” from the vendor to the end customer. As a result of these characteristics, brokers will have high variable expenses with only minimal fixed expenses. The balance sheet of a broker should look like Diagram 4, left.

[Diagram 4 is no longer available. — Ed.]

The only way a true broker can incur large losses is through the balance sheet risk of bad Debt write-off. Notice that the broker does not need to borrow funds from short-term lenders. Brokers tend to tenor match their working capital demands. They sell on net 30-day terms and collect in 45 days. They purchase on net 30-day terms and pay in 45 days. This is known as a perfectly timed asset conversion cycle. Gross margins are typically 4 percent to 10 percent low risk/low reward. Notice that the unsecured creditors take all the risk of bad Debt write-off.

This diagram should only be used as a benchmark. If a subject broker has a different picture from the diagram it does not necessarily mean there is a financial statement fraud. Differences from the benchmark should lead to further examination. There may be legitimate reasons for the different portrayals, but now we have learned a great deal about the subject company rather than rehashing the results of ratios that may not make sense.

The entire crux of the balance sheet, profit and loss, and ultimate cash flow depend on the quality, accuracy, and authenticity of Accounts Receivable. Be sure to carefully plan, construct, and follow through on the confirmations and verifications of Accounts Receivable for a broker. Consider the potential and use techniques to avoid such schemes.

A distributor will present a different picture because of the risk of carrying Inventory and some level of investment in warehouse and transportation equipment. A good benchmark view of a distributor will look like Diagram 5, left.

[Diagram 5 is no longer available. — Ed.]

The typical distributor should have more Accounts Receivable than Inventory. The only Inventory investment is in finished goods; some products will move quickly while others move a bit slower. The Inventory mix for a distributor should provide a relatively quick turn. There should be some Equity in Net Fixed Assets and the bulk of the trading assets are typically funded by Short-term Debt.

Distributors with the above profile typically have a permanent working capital need to borrow from banks or other commercial lenders. They sell on net 30-day terms, but collect the Accounts Receivable in 60 days. They plan to keep 30 days stock, but turn the Inventory in 45 days. Their combined trading asset turn of 105 days cannot be funded by 45 days of Accounts Payable and 10 days of Accrued Expenses. Due to this permanent gap, there is a permanent, “evergreen” need for short-term, revolving Debt.

The risk profile for the distributor advances to bad Debt write-off, and slow-moving and obsolete Inventory.

Gross margins are expected to be higher as medium risk/medium reward demands 10 percent to 20 percent. Also, as demonstrated above, the permanent working capital need brings in a new stakeholder, the commercial lender.

If our subject distributor had more dollars invested in Inventory than Accounts Receivable, we would focus a great deal on testing that subject Inventory. We would still concentrate efforts on confirming the receivables.

The manufacturer will have yet a different profile. See Diagram 6, left.

[Diagram 6 is no longer available. — Ed.]

The balance sheet risk now expands to include not only bad debt write-off and obsolete and slow-moving Inventory but also inefficient machinery and equipment.

The gross margins of a manufacturer should reflect high risk/high reward from 20 percent to 50 percent.
In this case, the Inventory investment is expected to exceed the investment in Accounts Receivable because most manufacturers hold raw material, work-in-process, and finished goods. If the subject company had a greater investment in Accounts Receivable, we would want to test the revenue recognition procedures, cut-off procedures, and confirm the Accounts Receivable closely.

If any of our subject companies had a large investment in “due from affiliates,” we would want to investigate the journal entries that reflect that Asset. An investment of Goodwill that appears to make up 40 percent of the Asset side of the balance sheet should draw serious investigation regarding impairment review, or the details of items capitalized versus expensed.

Many Uses for Common-size Diagram

The common-size diagram can be used as a fraud profile tool by matching expectations to an existing case and discovering anomalies. In addition, it can be used as a communications tool when a number of people are planning and discussing an audit. And the diagram can demonstrate the “before and after” picture. So if there are fraud findings and the balance sheet is corrected, the pro-forma picture can demonstrate the impact of the fraud to a wide audience.

The common-size diagram is not a panacea. Analyzing financial statements is always a painstaking process of benchmarks, exceptions, and examinations. But then how can you analyze a company without expectations? Try drawing a few diagrams. It might be another useful tool in your fraud detection kit.

Scott Mitchell, CFE, is vice president and borrower audit manager of FINOVA Capital Corporation in Los Angeles, Calif.