The statement of cash flows is typically broken down into three categories: 1) cash from operations, 2) cash from investing activities, and 3) cash from financing activities. Forensic accountants often apply ratio analysis to detect unusual changes in cash from operations that might indicate fraud.

Examples of amounts to compare to cash from operations include: 

• Changes in revenue and income from operations,
• Changes in working capital accounts,
• Asset purchases,
• Dividends paid,
• Current and long-term debt payments, and
• New loan proceeds. 

If a company reports an increase in cash flow from operations, it’s unlikely to borrow money or seek additional capital from owners. Instead, it’s more likely to repay debt or pay dividends.

Monitor Related Accounts 

Certain accounts tend to have stable relationships over time. That is, an increase in one account generally brings a similar increase in a related account. For example, in many companies, there’s a predictable relationship between:

1. Revenue, accounts receivable and inventory,
2. Inventory and accounts payable, and
3. Fixed assets and depreciation expense.

To illustrate, if ABC Company reports a significant increase in revenue in 2021, you’d expect to see a proportionate increase in receivables. Likewise, the company may need to carry more inventory to meet increased customer demand. If the statement of cash flows reveals a decrease in either account, it could indicate that the company is reporting fictitious revenue. However, there also could be a reasonable explanation. In this hypothetical case, ABC Company hired a CFO in January who focused on improving collections and implementing a just-in-time inventory program that significantly reduced the company’s investment in working capital.

Not every red flag indicates fraud — but red flags do require further investigation to determine what happened and why. In some cases, red flags may indicate inefficiencies, poor business practices or erroneous accounting practices. Early detection can help mitigate losses.

When a company is struggling, its statement of cash flows may show a net decrease in cash from operations. To make ends meet, the company may generate cash through bank loans, infusions of investor capital and asset sales.

To avoid showing the signs of financial distress, management may artificially boost cash from operations to make the company temporarily appear healthier. For example, the company might defer payments to vendors, finance payables or transfer receivables to a variable interest entity to inflate cash from operations. These techniques may qualify as financial misstatement, if the intention is to mislead investors, lenders and other stakeholders to protect or enhance the perpetrator’s financial interests.
 

 theKFORDgroup litigation team holds extensive knowledge and experience in expert witness engagements, forensic accounting, and business valuations. Our experts are trained and experienced in the litigation process. We can provide insight into financial reporting anomalies for you or your client. For more information, please call us at 210-340-8351. 

Additional information included in this report was provided by PDI Global/Thomson Reuters  © 2021