Quiz 12: Revenue- and Inventory-Related Financial Statement Frauds

Business

During the audit of major client, we notice that the revenues have increased dramatically from the third to the fourth quarter and especially over the previous periods of last year. We would take the following steps to examine the legitimacy of management's assertion regarding its reported revenue: As with the revenue related frauds, we can examine the legitimacy by focusing on inventory and cost of goods sold relationship using two primary methods that focus on changes from period to period. The first is to examine the ratio change from one period to another. The second is to convert the financial statements to common size statements, and use vertical analysis to examine the percentage changes from periods. The most helpful ratios used to examine the inventory and cost of goods sold relationships are as follows: Gross profit ratio is calculated by dividing gross profit by sales. The reason this ratio is helpful for identifying inventory frauds is that when a company overstates its inventory balance, the cost of goods sold is usually understated. The result is increase in gross profit ratio. Thus, a significant increase in gross profit ratio is a signal that either revenue or an inventory related fraud is committed. Inventory turnover ratio is computed by dividing cost of goods sold by the average inventory and is useful for determining whether inventory is overstated or cost of goods sold is understated. Overstating of inventory or understating of cost of goods sold both will decrease the ratio. Number of days sales in inventory measures the average time it takes to sell the inventory and is computed by dividing number of days in a period by inventory turnover ratio. When a company overstates inventory or understates cost of goods sold, the number of days sales in inventory increases. Also when company overstates its inventory and understates its cost of good s sold, net income is artificially increased causing this ratio to increase. There are four other ratios which can also help in examining the legitimacy of the company financial statements, even though they are not as sensitive as the three ratios discussed above but sometimes asset turnover ratio, working capital turnover ratio, operating performance ratio, and earning per share help in identifying fraud. The second way to focus on financial statement relationships is to convert the financial statements to common size statements and perform vertical analysis. If inventory as a percentage to total assets or as a percentage of sales keep increasing, or if cost of goods sold as a percentage of net sales keep decreasing, fraud may have occurred.

During the audit of major client, we notice that the revenues have increased dramatically from the third to the fourth quarter and especially over the previous periods of last year. We would take the following steps to examine the legitimacy of management's assertion regarding its reported revenue: As with the revenue related frauds, we can examine the legitimacy by focusing on inventory and cost of goods sold relationship using two primary methods that focus on changes from period to period. The first is to examine the ratio change from one period to another. The second is to convert the financial statements to common size statements, and use vertical analysis to examine the percentage changes from periods. The most helpful ratios used to examine the inventory and cost of goods sold relationships are as follows: Gross profit ratio is calculated by dividing gross profit by sales. The reason this ratio is helpful for identifying inventory frauds is that when a company overstates its inventory balance, the cost of goods sold is usually understated. The result is increase in gross profit ratio. Thus, a significant increase in gross profit ratio is a signal that either revenue or an inventory related fraud is committed. Inventory turnover ratio is computed by dividing cost of goods sold by the average inventory and is useful for determining whether inventory is overstated or cost of goods sold is understated. Overstating of inventory or understating of cost of goods sold both will decrease the ratio. Number of days sales in inventory measures the average time it takes to sell the inventory and is computed by dividing number of days in a period by inventory turnover ratio. When a company overstates inventory or understates cost of goods sold, the number of days sales in inventory increases. Also when company overstates its inventory and understates its cost of good s sold, net income is artificially increased causing this ratio to increase. There are four other ratios which can also help in examining the legitimacy of the company financial statements, even though they are not as sensitive as the three ratios discussed above but sometimes asset turnover ratio, working capital turnover ratio, operating performance ratio, and earning per share help in identifying fraud. The second way to focus on financial statement relationships is to convert the financial statements to common size statements and perform vertical analysis. If inventory as a percentage to total assets or as a percentage of sales keep increasing, or if cost of goods sold as a percentage of net sales keep decreasing, fraud may have occurred.

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