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Spotting Business Financial Statement Fraud

Part of the Forensic Accounting 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. A business that engages in such a practice stands to lose a tremendous amount of money when penalties and fines, legal costs, the loss of investor confidence, and reputational damage are taken into account.

When a forensic accountant investigates business financial fraud, she looks for red flags or accounting warning signs. Red flags that indicate suspect business accounting practices include

  • * 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 cannot be attributed to seasonality

  • Growth in inventory that does not 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 is declining

  • Growth in revenues that is 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 are not 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 is impossible to determine the actual nature of the transaction

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

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

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