Question

Which of the following is an indicator of possible financial reporting fraud being perpetrated by management of a manufacturer?

A. A cross-sectional analysis of common size statements discloses that (1) the firm's percentage of cost of goods sold to sales is 50% and (2) the industry average percentage of cost of goods sold to sales is 40%.
B. A ratio analysis discloses that cost of goods sold is 50% of sales.
C. A trend analysis discloses (1) sales increases of 50% and (2) cost of goods sold increases of 25%.
D. A cross-sectional analysis of common size statements discloses that (1) the firm's percentage of cost of goods sold to sales is 40% and (2) the industry average percentage of cost of goods sold to sales is 50%.

Answer 1

Scenario C, with inconsistent sales and cost of goods sold increases, is an indicator of possible financial reporting fraud, as it could suggest inflated sales or unrecorded expenses.

Step-by-step explanation:

An indicator of possible financial reporting fraud perpetrated by management may be hinted at through various forms of financial analysis. The question presents four scenarios, but the most concerning one from the perspective of potential fraud is C, where a trend analysis discloses a large increase in sales relative to the cost of goods sold. Such a discrepancy could indicate that management could be inflating sales figures or not recording all expenses, which may be red flags for fraudulent activities.

However, it's important to consider that these analyses alone do not provide conclusive evidence of fraud. They merely serve as signs that warrant further investigation. It is also worthwhile to explore the Four-Firm Concentration Ratio and the Herfindahl-Hirschman Index as these inform about market power concentration, which, while related to competition, does not directly signal financial reporting fraud but can contribute to the firm's strategic behaviors within the industry.