By Evgeniya Sukhova—-
In order to detect material misstatements in the financial statements of a company, auditors perform numerous analytical procedures, including analysis of relationships between financial and nonfinancial information. Inconsistency between financial and nonfinancial information can be a symptom of financial statements fraud. This type of fraud is most often carried out by management of a company under pressure to meet expectations of market analysts, debt covenants requirements, and/or to comply with tightly performance-based compensation program. It is relatively easy for management to override internal controls and manipulate financial information by falsifying journal entries and recording transactions at the wrong time. In contrast, it is much more difficult or impossible to manipulate nonfinancial information, especially when it is provided by unrelated sources from outside, like industry quality rankings and customer satisfaction surveys.
Usually, management uses the following methods to falsify financial information: overstating revenues, profits, and assets and understating expenses, losses, and liabilities. Revenue overstating is considered “the most common way” to improve a company’s performance on the financial statements (Coenen, “Expert Fraud Investigation”). Some of the key non-financial performance indicators that auditors can analyze in regards to correlation with revenue are as follows: the number of facilities/stores, square footage of production facility, the number of customer accounts, the number of employees and their turnover, and the number of products.
If a company reports enormous revenue growth, the number of facilities/stores (for a retailer) or square footage of a production facility (for a manufacturing company) should be considered. If revenue is increasing at a greater rate than the number of facilities, this inconsistency indicates a likelihood of fraud and deserves closer attention from an auditor.
The same pattern should be observed regarding relationship between reported sales/revenue and the number of employees and their compensation, the number of customer accounts and the number of products. If a company shows significant sales and revenue growth while any of the non-financial indicators mentioned above is decreasing (for example, the number of employees is decreasing due to lay-offs) – this is a “red flag“ for an auditor indicating possible revenue overstating.
As an example illustrating how warning signs of inconsistency between financial and non-financial information was missed by auditors and the board of directors, HealthSouth Corporation fraud can be considered. This $1.7 billion financial statement fraud lasted for 7 years before it was discovered in 2003. During that period, the company reported increasing revenue and assets while the number of its facilities was decreasing. If auditors had not failed to evaluate connection between reported revenue and the number of HealthSouth operating facilities, this fraud might have been discovered earlier, and its consequences would have been less devastating.
Obviously, analytical procedures focused on comparing financial information with non-financial performance indicators can enhance quality of an audit and increase chances to detect symptoms of financial statements fraud. The role of non-financial information provided by independent sources is very important in detecting financial statements fraud because it is least likely to be manipulated by management, thus, enabling auditors evaluate reliability of management’s explanation of revenue growth and other favorable trends in the company’s financial statements.
Master of Science in Accounting 2014
University of St. Thomas, Cameron School of Business
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