By B.J. Hoffman
Special to the Legal
It is not uncommon to hear executives air concerns about possible exposure to internal fraud. In such cases, company owners are typically unable to put their finger on exactly what might be wrong other than having an uneasy feeling about a particular employee, or group of employees, a controller, a CFO, or another individual with access to company assets. Though there may be red flags of untoward behavior by employees – unexplained spending, working odd hours, sloppy record-keeping – company owners are generally at a loss as to how to explore potential fraud further.
The most effective first step in determining whether further investigation is warranted is ratio analysis applied to historical company financial results. Ratio analysis serves to highlight financial anomalies and trends, identifying areas of financial risk for additional testing. In its simplest form, ratio analysis is merely the evaluation of company historical results over several years.
I typically want to have five years of company data (internal financial statements or tax returns) available when performing ratio analysis, laid out by year in an electronic spreadsheet. Horizontal and vertical ratio analysis is the usual starting point in any investigation.
Horizontal Ratio Analysis
Horizontal analysis is the evaluation of a particular line item’s trend over a multi-year period. For instance, if the company reported that advertising expenses have increased by 100 percent from 2008 to 2013, is that reasonable or have fictitious expenses been coded in the advertising category?
Vertical Ratio Analysis
Vertical ratio analysis compares one line item with another in a given year. For instance: advertising expenses versus sales revenue. If the company advertising expenses approximate 2 percent of annual sales from 2008 through 2011, but jump to 8 percent of sales in 2012 and 2013, perhaps the underlying details of 2012 and 2013 advertising expenses should be explored. Maybe the jump in expenses is the result of a new 2012 advertising campaign or, alternatively, perhaps the advertising expense increase coincides with the hiring of the company’s new controller.
Exploring Ratio Analysis Further
Ratio analysis can be much more detailed than horizontal and vertical evaluations. Certain ratio analysis tests are designed to examine the speed of a company’s collection of its accounts receivable over time, its gross margin on inventory sales, or the rates of customer refunds issued by a particular retail cashier.
If accounts receivable collections are slowing over time, is someone in the accounts receivable department stealing customer payments? If gross margins on product sales are declining, is a warehouse employee misappropriating inventory? If one cashier’s rate of refunds issued is greater than all others, is that cashier fabricating refunds and pocketing cash?
Ratio analysis is a flexible tool and can be tailored to the individual department under scrutiny. It can assist in overseeing operations from 30,000 feet, or it can be designed to drill down at an excruciatingly detailed level, such as in analyzing stadium beverage sales by vendor location, for a given ticketed attendance, under set weather conditions, etc.
The beauty of ratio analysis as an investigative tool is that it cuts to the chase, identifying likely areas for more intensive testing. When fraud is a concern but management has little else to go on, open the ratio analysis toolbox to find the needle in the haystack.
B.J. Hoffman is a certified public accountant and certified fraud examiner for Citrin Cooperman, an accounting, tax and business consulting firm. He is a partner in the Philadelphia office. Hoffman provides clients with a mix of audit, tax and litigation support services. He often works with closely held entities in a variety of industries, including professional service firms and real estate enterprises. He can be reached at firstname.lastname@example.org or 215-545-4800.