Lecture Note # Financial Statement Analysis

 Comparative financial statements provide information for current and

past accounting periods.
 Accounts expressed in whole rupee /dollar amounts yield a limited
amount of information.
 The conversion of these numbers into ratios or percentages allows the
reader of the statements to analyze them based on their relationship to
each other; in addition, it allows the reader to more readily compare
current performance with past performance. In fraud detection and
investigation, the determination of the reasons for relationships and
changes in amounts can be important. These determinations are the red
flags that point a fraud examiner in the direction of possible fraud.
 If large enough, a fraudulent misstatement can affect the financial
statements in such a way that relationships between the numbers become
questionable.
 Many schemes are detected because the financial statements do not make
sense when analyzed closely. Financial statement analysis includes the
following:
 Vertical analysis
 Horizontal analysis
 Ratio analysis

Horizontal Analysis
 Horizontal analysis is a technique for analyzing the percentage change in
individual financial statement line items from one accounting period to
the next.
 The first period in the analysis is considered the base period, and the
changes in the subsequent period are computed as a percentage of
the base period.
 If more than two periods are presented, each period’s changes are
computed as a percentage of the preceding period. The resulting
percentages are then studied in detail. As is the case with vertical
analysis, this technique does not work for small, immaterial frauds.
Vertical Analysis
 Traditionally, there are two methods of percentage analysis of financial
statements: horizontal and vertical analysis.
 Vertical analysis is a technique for analyzing the relationships among the
items on an income statement, balance sheet, or statement of cash flows
during a specific accounting period by expressing components as
percentages of a specified base value within the statement being
analyzed.
 This method is often referred to as common sizing financial statements
because it allows an analyst to compare entities of different sizes more
easily.
 In the vertical analysis of an income statement, total sales are the base
value and are assigned 100%. This means that every line item on the
income statement is stated as a percentage of total sales.
 On the balance sheet, total assets are assigned 100% on the asset side and
total liabilities and equity are expressed as 100%.
 In turn, each line item on the balance sheet is stated as a percentage of
total assets (or total liabilities and equity). Vertical analysis of a cash flow
statement shows each cash inflow or outflow as a percentage of the total
cash inflows. Vertical analysis emphasizes the relationship of statement
items within each accounting period. These relationships can be used
with historical averages to determine statement anomalies

The following is an example of financial statements that are analyzed using both
horizontal and vertical analysis:
In the example, we can observe that accounts payable makes up 29% of
total liabilities in Year One. Historically, we might find that this account
averages slightly over 25% of total liabilities. In Year Two, accounts payable,
as a percentage of total liabilities, increased to 51%. Although this increase
might be explainable through a correlation with a rise in sales, such a significant
increase could also be the starting point of a fraud examination. Source
documents should be examined to determine the reason for the rise in this
percentage. With this type of examination, fraudulent activity might be
detected. The same type of change can be seen as selling expenses decline as a
percentage of sales in Year Two from 20% to 17%. Again, this change might be
explainable, but close examination could point a fraud examiner to uncover
fictitious sales since there was not a corresponding increase in selling expenses.
It is important to consider the dollar amount of change as well as the
percentage when conducting a horizontal analysis. A 5% change in an
account with a very large dollar amount could actually be much more of a
change than a 50% change in an account with much less activity.
In the example, it is obvious that the 80% increase in sales has a much
greater corresponding increase in cost of goods sold, which rose 140%.
These accounts are often used to hide fraudulent expenses, withdrawals, or
other illegal transactions.

Ratio Analysis
Ratio analysis is a means of measuring the relationship between any two
different financial statement amounts. The relationship and comparison are the
keys to the analysis. Many professionals, including bankers, investors, and
business owners, as well as major investment firms, use this method. Ratio
analysis allows for internal evaluations using financial statement data.
Traditionally, financial statement ratios are compared to an entity’s industry
averages