13 Ways to Spot Fraud in Business Financial Statements

Part of the Accounting All-In-One For Dummies Cheat Sheet

Financial statement fraud, commonly referred to as "cooking the books," involves deliberately overstating assets, revenues, and profits and/or understating liabilities, expenses, and losses. When a forensic accountant investigates business financial fraud, she looks for red flags or accounting warning signs that indicate suspect business accounting practices.

These red flags include the following:

  • Aggressive revenue recognition practices, such as recognizing revenue in earlier periods than when the product was sold or the service was delivered

  • Unusually high revenues and low expenses at period end that can't be attributed to seasonality

  • Growth in inventory that doesn't match growth in sales

  • Improper capitalization of expenses in excess of industry norms

  • Reported earnings that are positive and growing but operating cash flow that's declining

  • Growth in revenues that's far greater than growth in other companies in the same industry or peer group

  • Gross margin or operating margins out of line with peer companies

  • Extensive use of off–balance sheet entities based on relationships that aren't normal in the industry

  • Sudden increases in gross margin or cash flow as compared with the company's prior performance and with industry averages

  • Unusual increases in the book value of assets, such as inventory and receivables

  • Disclosure notes so complex that it's impossible to determine the actual nature of a particular transaction

  • Invoices that go unrecorded in the company's financial books

  • Loans to executives or other related parties that are written off

A business that engages in such fraudulent practices stands to lose a tremendous amount of money when penalties and fines, legal costs, the loss of investor confidence, and a tarnished reputation are taken into account.

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