When thinking about the ways financial experts can uncover fraud, data analysis and other forensic accounting techniques may come to mind. But qualified experts also know how to use everyday managerial accounting practices to ferret out fraud.
Budgets can provide insight into how management expects a company to perform in the near future. As such, budgets might highlight unusual transactions and other developments that fall outside of management’s expectations and warrant further investigation.
Budgets can also play a role in fraud deterrence. Creating budgets typically requires input from people across the organization. Such interdepartmental communication and information sharing provides an informal fraud “screen” that makes it harder for perpetrators to manipulate the financial results. Would-be thieves may be deterred by the idea that managers and co-workers in other departments are paying attention to what they’re doing.
After a budget has been finalized, management may review it and investigate differences between actual and budgeted performance to find the causes. For example, if actual wages significantly exceeded budgeted wages, the difference could be due to wage increases, productivity declines, greater downtime, unexpected demand for the company’s goods or services, or a combination of these possibilities. It could also signal phantom employees on the payroll, however.
When it comes to fraud detection, experts pay particular attention to variances related to inventory and purchase pricing. For example, variances between the actual and budgeted pricing for supplies could suggest the existence of:
- Kickbacks, where the perpetrator takes a cut from a vendor that inflates its prices, or
- Fictitious vendors, where the payments go to the perpetrator and no inventory is received in exchange, requiring the organization to spend more money to restock inventory.
If a scheme involves the purchase of subpar materials or fewer units than ordered, it could show up in spoilage or other inventory-related variances.
Conversely, the absence of variances when they would be expected can be cause for concern. For example, an organization may have run into an unanticipated price jump for a critical component, which would understandably lead to a purchase price variance. If no such variance is found, it could be a sign of financial reporting fraud.
The term “contribution margin” generally refers to the difference between a unit’s sale price and its variable costs. It’s often used to make pricing decisions, calculate breakeven point, and evaluate profitability. But contribution margin analysis also can be used to detect fraud schemes, such as skimming or inventory theft.
The key lies in the contribution income statement. The traditional financial accounting income statement (also known as a profit and loss statement) initially computes a gross margin (revenues less variable and fixed manufacturing costs). But the contribution income statement first calculates the contribution margin (revenues less variable manufacturing and nonmanufacturing costs). Contribution margin as a percentage of revenue should remain fairly consistent over time.
If the contribution margin is dramatically lower than usual, fraud could be to blame. Perhaps an employee is understating revenue to hide skimming — but the margin would fall because the variable costs relate to the actual sales, not the falsely lower sales that are reported.
While the techniques explored here can raise red flags that fraud is occurring, it’s important to remember that red flags aren’t solid evidence. When fraud is suspected, a forensic accounting specialist can help you make a defensible determination.