FAR 750

FINANCIAL STATEMENT RATIO ANALYSIS

TO DETECT RED FLAGS ON FINANCIAL
REPORTING FRAUD
FAUZUAN RAJA NASRUL IDZHAR BIN RAJA
FAUZI ISMAIL

NOR AYU BINTI SURIAMI BINTI

AWANG SIMAN SULAIMAN
 TABLE OF CONTENTS

01 02 03
INTRODUCTION LITERATURE REVIEW DISCUSSIONS

04 05
CONCLUSIONS REFERENCES
01 INTRODUCTION
 INTRODUCTION
Duchac et al., 2007
✓ The financial statements of a
company have become a
responsibility and obligation to
01 disclose to stakeholders
Dewi & Anisykurlillah, 2021
✓ Eg: investors, governments,
Objective of Financial creditors, banks, & the general
Reporting :
02
public

✓ Offer critical information

about a company's
performance

✓ Interested parties can

03 A vast number of users
benefited from high-quality
make policy, action, and data when making
decisions economic decisions.
 INTRODUCTION
01 02 03
Poor quality of
financial statement External auditors also face a
information can serious challenge with
reduce the level of Financial reporting fraudulent financial
accuracy of flaws have resulted in reporting
stakeholders in high-profile scandals ✓ harm to their
making economic that have resulted in professional reputation
decisions not only investor losses ✓ undetected fraud
but also a loss of trust in
the financial system.
 INTRODUCTION

Mohamad Kamal et al. (2016),

✓ 82% of public listed companies prosecuted by the Securities

Commission Malaysia for false financial reporting were
identified for manipulating earnings and deception in financial
statements during the fraud year prior to a public
announcement.

✓ Eg: Megan Media Holdings Bhd., Mems Technology Berhad,

Transmile Group Bhd., Axis Incorporation Berhad, Multi-Code
Electronic Industries (M) Berhad, Mems Holdings Bhd, Polymate
Holdings Berhad, and Silver Bird Berhad

✓ Resulted in a total misrepresentation worth billions of dollars

 INTRODUCTION
14% cases in Asia Pacific
11% Sub-Saharan Africa
7% government organisations
✓ Financial statement fraud is the most damaging
sort of fraud, as seen by this fact. 10% banking and financial services

11% Western Europe

✓ Financial statement fraud is reported in:
10% Eastern Europe and Western/Central Asia
7% the Middle East and North Africa,
19% Latin America and the Caribbean,

FRAUD REDFLAG FS ANALYSIS 12% Southern Asia

Financial statement fraud schemes have the fastest median

velocity, with USD 39,800 per month, according to the "Report to
the Nations." (ACFE, 2020).
INTRODUCTION
Red flags

✓ “potential symptoms existing within the company’s business environment

that would indicate a higher risk of an intentional misstatement of the
financial statements” (Price Waterhouse, 1985).

✓ Yucel (2013) most important red flags in literature can be listed into
two terms of fraud which are Red Flags on Fraudulent Financial
Reporting and Red Flags on the Abuse of Assets.

Accounting and Document

Abnormalities
Red Flags on
Fraudulent Financial
Reporting have two
types:
Managerial Abnormalities
 LITERATURE REVIEW
Accounting and Document Abnormalities
✓ High balance of reported income and sales
accounts,
✓ low number of sales discounts and refunds,
✓ absence or lack of allowance accounts,
✓ excessive increase in trade receivables,
✓ mostly accrued reported income,
✓ absence of original documents,
✓ failure to declare important bank accounts,
✓ inconsistencies between incomes,
✓ sales and receipt of payment or other supporting
evidence (Albrecht et al., 2011)
✓ insufficient explanation in balance sheet
footnotes,
✓ seasonal differences,
✓ generation of fictitious income and improper
asset valuation, (Singleton and Singleton, 2010)
amongst the red flags.
Managerial Abnormalities
✓ A red flags when company have unusual
profits,
✓ making company’s stock prices an obsession,
✓ adoption of a micro-management style
which signifies an attempt by the upper
management to execute the duties of
subunits, (Singleton and Singleton, 2010)
✓ significant lawsuits and investigations filed
against the company,
✓ management team with high personal debt,
✓ dishonest and unethical management staff,
✓ management have secret agreements with
third parties,
✓ adoption of a management policy with a
high personnel turnover rate (DiNapoli,
2010),
 INTRODUCTION
Therefore, the red flags must be known so as not to cause harm to various parties.

01
Ruankaew (2013)

✓ Understanding the causes that trigger the ✓ Before reducing fraud and

fraud managing the risk of fraud

✓ Adopting proactive actions to combat it ✓ The organisation must first

can help to reduce it. identify the reasons that cause

✓ Understanding why people commit fraud the fraud.

02
is crucial in order to decrease the number

of fraud incidents (Napel, 2013).

LITERATURE REVIEW 02
LITERATURE REVIEW ✓When one or more people,
referred to as principals,
hire one or more people,
referred to as agents,

Jensen & Meckling (1976)
AGENCY THEORY
✓ the relationship can be
viewed as a close
interaction between
the shareholder and
the company's
operations
✓To carry out all of the PRINCIPAL & AGENT
business's operations on
behalf of the principals'
interests, an agency
relationship is formed
✓ Asymmetry of
information is created
by this situation.

✓ Management should
run the business in the ASYMMETRY INFO
owner's best interests

✓ Information asymmetry determines the
opportunistic behavior of the manager
(agent).
✓ In fact, it employs all available data,
including earnings management, at its
discretion.
✓ The manager would use accounting
approaches that increase the result by
utilising the flexibility of accounting
concepts.
✓ As a result, he will commit an irregular
"Fraud" to cover up bad performance and
implement a programme of rooting that
translates into accruals in activities where
the officer has a competitive advantage in
terms of personal or informational
competence (Djama, 2008).
LITERATURE REVIEW
The problem of knowledge
asymmetry lies at the heart of
02
any conflict of interest issue, and
it raises the danger of fraud as a
result
01
✓ To overcome agency problems,
the agency cost is needed to
03
incurred by the principal and
agent.
✓ There are three types of agency
cost which are monitoring cost,
binding cost and residual losses.

✓ One of the most common
methods for financial analysis is
by ratio analysis
(Subramanyam & Wild, 2009).
✓ Ratio analysis is a technique for
determining the relationship
between two financial
statement figures.
LITERATURE REVIEW
✓ Ratio analysis may make
these frauds easier to
uncover because non-
management personnel
would not have access to
accounting cover-ups of non-
accounting frauds.
✓ Anomalies in ratios may
indicate the presence of
fraudulent activities.
✓ Accounting frauds can be far
subtler, necessitating a further
inquiry beyond a warning sign
that something isn't quite right.
SYNTHESIS
Agency theory is the main theory that can describe the root

01
of the financial reporting fraud to happened.

✓ The relationship between
principal and agent can be
seen that agent tend to
maximize their own profit and
to show their best
performance so that they start
faking their performance in
financial statement.
02 03
✓ For principal, they need to
✓ Financial difficulties incurred agency cost as to
may be one of the monitor the behavior of
motivation for their hired agent and so
managers to engage need to do ratio analysis
in fraudulent as to raise red flag on
activities. whether their agent is
doing fraudulent financial
reporting or not.
 SYNTHESIS
✓ Izzalqurny et al., 2019; Repousis, 2016 found that
profitability has a positive impact on the risk of
financial statement fraud.

✓ Zainudin and Hashim (2016), Lisic, et al. (2014),

✓ A primary motivating reason for fraud is and Dalnial, et al. (2014) found that profitability
poor financial performance (Ozcan, ratio has a negative impact on fraudulent financial
2016). reporting,

✓ Ozcan (2016), organisations with higher ✓ Zainudin and Hashim (2016), Lisic, et al. (2014),
liquidity levels are more prone to provide and Dalnial, et al. (2014) found that profitability
false financial statements. ratio has a positive impact on fraudulent financial
reporting.
✓ Liquidity, according to Izzalqurny et al.
(2019), has a detrimental impact on the
risk of financial statement fraud.
DISCUSSIONS
03
 DISCUSSIONS
RATIOS
The study of ratios is used as one of the
approaches to discover fraud in research
projects (Feroz et al., 1991; Spathis et al.,
2002; Lenard & Alam, 2009; Ravisankar et al.,
2011).
we will do discussion one by one
ratios analysis that is commonly
used and
discuss on how it can be used to
detect financial reporting fraud.

RAISE RED FLAG

But the question is how does
financial statement ratios analysis
raise red flag for financial
reporting fraud?
 CONCLUSIONS
CURRENT RATIO COLLECTION RATIO
01 ASSET TURNOVER
06 RATIO
DEBT-TO-EQUITY 08
RATIO

02 03 04 07 INVENTORY
TURNOVER RATIO
RECEIVABLE
QUICK RATIO TURNOVER RATIO
09
05
PROFIT MARGIN AVERAGE NUMBER OF DAYS INVENTORY
RATIO IS IN STOCK RATIO
 DISCUSSIONS
01 CURRENT RATIO
✓ This ratio might be a good sign of account
manipulation when it comes to detecting fraud.
✓ Lower liquidity may be an incentive for managers to
engage in fraudulent financial statements and can be
considered as red flag.
✓ Fanning & Cogger (1998), Kirkos et el. (2007),
Ravisankar et al. (2011), the higher levels of debt may
increase the probability of the fraudulent financial
statements too.
✓ The ratio will fall as a result of embezzlement.
✓ A more advantageous ratio will result from liability
hiding.
QUICK RATIO 02
✓ This ratio assesses a company's ability to handle
unexpected cash needs.
✓ Eg: The company balance sheet in year one has quick ratio
of 3.0.
✓ Then, in year two, the ratio falls to 1.0.
✓ A closer examination of accounts receivable reveals that
they are expanding at an exceptional rate, the exceptional
rate expanding can be the red flag and can be from the
fictitious accounts receivable have been introduced to
exaggerate sales.
 DISCUSSIONS
DEBT-TO- PROFIT
EQUITY RATIO 03 04 MARGIN RATIO
✓ This ratio of net income to sales looks at the
✓ The ratio is carefully scrutinised by lending institutions
implications of changes in gross margin as well as
since it provides a picture of the relative risk borne by
changes in selling and administrative expenses.
creditors and owners.
✓ If fraud is conducted, net income may be falsely
✓ The bigger the risk assumed by creditors, the more
inflated, resulting in an abnormally high profit margin
difficult it will be for the owners to obtain cash by
ratio when compared to previous periods.
increasing long-term debt.
✓ False expenditures cause expenses to rise and the
✓ In the situation that debt is rapidly expanding in
profit margin ratio to fall.
relation to equity, the rise in the ratio might
corresponds to the rise in accounts payable.
✓ Over time, this ratio should be rather stable.
✓ Changes in this ratio that occur suddenly may alert as
a sign or red flag to fraud examiner to look for fraud.
 DISCUSSIONS
RECEIVABLE
05 TURNOVER RATIO
✓ This is a ratio that examines both the income statement and
the balance sheet accounts.
✓ This false income will never be collected if fictitious sales
have been registered.
✓ As a result, receivables turnover will be reduced.
✓ This fictitious revenue will never be collected if the fraud is
triggered by fictitious transactions.
✓ Eg: the accounts receivable turnover goes from 3.0 to 1.0.
✓ This can raise red flag and ratio can be used by a fraud
examiner to determine whether or not revenues are false,
necessitating further investigation of source documents.
COLLECTION RATIO
06
✓ This ratio can be used as a first step in discovering fraudulent
receivables, as well as theft and skimming scams.
✓ Changes in billing procedures or collection activities may create
a fluctuation in this ratio from year to year.
✓ When the collection ratio is increased over years, this can raise
as red flag as the collecting of receivables is getting slower that
might be from fraudulent sales that cannot be collected and
stored in the account receivables.
✓ So, when collection ratio is increasing, we can investigate
further and this might lead to whether fraudulent sales or just
maybe the internal debt collection department is not efficient.
 DISCUSSIONS
07 INVENTORY
TURNOVER RATIO
✓ This ratio will be exceptionally high if the cost of
goods sold has increased due to inventory theft
(ending inventory has decreased, but not through
sales).
✓ Inventory turnover increases in year two in the
case study, indicating the probability of an
embezzlement buried in the inventory account.
✓ To select a direction in which to discover suspected
fraud, a fraud examiner should look at changes in
the components of the ratio.
ASSET TURNOVER
RATIO
08
✓ The efficiency with which asset resources are
employed is measured by this ratio.
✓ An increased in this ratio may indicate a red flag
for investor which is maybe because of
overstating of asset by the company.
✓ Overstating can be from inventories
manipulation, fake sales that increasing the
account receivables.
 DISCUSSIONS
09
Average-Number-of-Days-Inventory-Is-in-Stock Ratio
✓ An increase in the number of days’ inventory remains in stock results in
increased expenditures, such as storage costs, inventory obsolescence risk, and
market price reductions, as well as interest and other fees spent as a result of
keeping funds in inventory stock.

✓ For fraud investigators, inconsistency or considerable variance in this

percentage is a red flag.

✓ This ratio can be used by fraud investigators to look into inventory records for
probable theft schemes.

✓ The ratio can be influenced by how you buy and receive inventory.

✓ A rise in the ratio is also caused by understating the cost of items sold.

✓ Significant variations in the inventory turnover ratio might be a solid indicator of

suspected inventory fraud.
04 CONCLUSIONS
 CONCLUSIONS
Financial statement ratios
financial statement ratio
analysis shall raise as red
flag in detecting financial
✓ Even there is no fraud involved, reporting fraud
financial statement ratios
analysis has given us the red flag
Ratios abnormal/odd
✓ Or point to look and search for
✓ The ratios are abnormal or evidence whether there is fraud
change oddly than average, this involved or it is only an
is a red flag unintentional mistake
✓ Investor or principal need to do
investigate further and look for
fraud
 05
REFERENCES
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