'Income smoothing' becomes fraud

A team of fraud fighters uses three different analytical tools for measuring accruals (amounts that aren't cash transactions) in a company and finds that some managers had added fraudulent loans to boost the numbers and keep the shareholders happy.

Solzarity Inc. was a mid-sized, well-respected community company that provided loan services to individuals. All looked fine on the surface. The financial statements painted a rather rosy future. However, the shareholders eventually questioned the financial information. Some of the financial ratios — such as the current ratio, working capital and working capital turnover — suggested lower liquidity issues. (This is an actual case, but we've changed the name of the firm.)

Now, the combination of lower liquidity and higher profitability isn't necessarily indicative of financial statement manipulation. For example, a company may be using cash earned from the profits to increase and/or improve capital assets. However, at some point, the available cash must be used to pay its bills and capital assets must shrink.