In the Claims Valuation and Litigation Support Group, we provide expertise on loss calculations for personal injury claims, business interruptions and other claims that may give rise to earnings loss. What is often required is an analysis of the financial statements and business records of sole proprietorships or corporations. We may need to ensure that the financial statements are a reasonable representation of the financial position of the business and that financial statements are accurate and reliable testaments to what would have happened (from a financial point of view). Occasionally, we come across statements where you can't help but think that there's something fishy going on.
While the opportunity for misstatement exists on each line of the financial statements, unreliable financial reporting may be achieved in the following ways:
- Manipulation of accounting records or documents from which the financial statements are prepared; or
- Omission of events, transactions or other significant information from the financial statements.
Unless specifically asked to determine whether fraud has occurred, we are seldom able to check every transaction to ensure that the possibility of misstatement is eliminated. Therefore, we focus on areas that are considered "risky," while considering whether the financial statements have been prepared with the intention of reflecting a higher net income (for the purposes of our calculations, this is a more likely scenario for a higher loss) or a lower net income (to minimize taxes paid). The most common ones are as follows:
- Revenues – Methods to misstate revenues
- Adjusting the timing of sales to improve the financial position before the loss occurred; and
- Failing to record sales, especially with cash transactions, and
not issuing invoices.
- Comparing sales amounts on the books with actual invoices and/or bank statements: Were all invoices sequentially numbered? Have the invoices been altered? Have cash transactions been recorded?
- Comparing the accounts receivable to sales: Have the accounts receivable increased from year to year? Is the balance in line with sales?
- Comparing sales levels, by month and by year, to similar
companies and to the overall industry: Do sales regularly fluctuate
monthly or yearly? Does the sales trend follow that of competitors
or the overall industry?
- Expenses – Some methods to misstate expenses
- Adjusting the timing to improve the financial position before the loss occurred; and
- Creating false expenses or paying unreasonable expenses to
lower net income (e.g., paying wages to, or personal expenses on
behalf of, family members who do not work for the company).
- Comparing balances by year: Were there large fluctuations between years? Does the total expense appear reasonable in comparison to the level of sales reported?
- Comparing the level of inventory to cost of sales and calculating gross margin ratios: Has there been an increase in the amount of inventory held from year to year? Has the gross margin fluctuated from year to year?
- Reviewing salaries and wages paid during the year for payments made to relatives; and
- Reviewing transactions made with related parties: What was the
nature and number of transactions? Were they at market value? Do
large payables exist on the balance sheet? Have all related parties
The above list is far from complete, especially in those cases in which we suspect significant inaccuracy. However, most of the time, we are simply assessing whether financial statements are reasonably reliable. In our line of work, we are trained to look for anything that looks unusual. If you think your financial statements look too good to be true, chances are we'll think so too.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.