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Financial Statement Analysis Methods in
Arson for Profit Investigations

by
Douglas O. Crewse

The arson for profit problem has become an ever-widening spiral upwards. Fire investigators, both public and private, must keep pace with new developments and ways to combat this trend. This article will hopefully assist investigators by successfully accomplishing the following objectives:

(1) Demonstrate the benefits of financial and accounting knowledge to the arson for profit investigator.

(2) Enable the investigator to recognize and prove financial motives for a business owner who may have committed arson for profit.

(3) Provide a guide regarding what information can be obtained through a review of financial statements and an analysis of those statements.

(4) Enable the investigator to recognize "red flags" that indicate a business was experiencing financial difficulty or systematically planning in advance to be out of business prior to the fire.

There are many types of financial motives in arson for profit investigations, the most common of which are:

(1) Avoiding insolvency

(2) Preventing further losses in the business

(3) Insurance fraud

(4) Disposal of inventory

(5) Real estate fraud

(6) Liquidating a business due to:

(a) Unprofitable contracts

(b) Partnerships or management differences

(7) Redecorating, relocating and/or renovating the business

To begin to understand and evaluate financial statements, one must be able to understand the conceptual as well as the technical side of accounting.

The accounting cycle, the conceptual side of accounting, is the step-by-step process used by the accountant throughout the year in reporting the financial transactions of the business. This accounting cycle consists of documents and records which when compiled constitute an accounting system. These documents and records substantiate and verify the financial records and financial statements of the business. The accounting cycle can be simplified as having the following basic steps:

(1) Making a journal of the transactions as they occur

(2) Posting of the journal entries to the general ledger

(3) Creating a trial balance to ensure accuracy in posting of previous journal entries

(4) Posting year-end adjusting entries

(5) Closing, which involves the transferring of account or sub-account balances into the main balance sheet account

(6) Preparing financial statements from ending account balances

The basic types of financial statements that each and every business may have available for review and analysis include the following:

(1) Balance Sheet

(2) Income Statement

(3) Accumulated Retained Earnings Statements

(4) Statement of Source and Application of Funds

(5) Analysis of Changes in Working Capital

Analysis of financial statements is critical in arson for profit investigations. Financial statements ans:

(1) Predicting the entity's future earnings and dividends

(2) Determining the riskiness of the firm

(3) Determining cash flow and solvency

(4) Anticipating future conditions of the entity

(5) Planning tool influencing future courses of action, such as expansion

In addition to the above reasons, investigators, law enforcement personnel and civil and criminal attorneys utilize these financial statements and supporting documents for showing motives and proving up their cases by showing:

(1) Loss of income

(2) Loss of cash flow

(3) Reduction in retained earnings

(4) Misappropriation of funds

(5) Embezzlement of funds

(6) Calculating unexplained Income

(7) Identification of assets

(8) Reduction in inventory

(9) Non payment of current and non-current liabilities

(10) Solvency v. insolvency

(11) Changes in financial condition

The two most important of these financial statements are the Balance Sheet and the Income Statement. [To illustrate the analysis described below, please refer to Figure 1, Figure 2, and Figure 3.] When the investigator becomes familiar with analyzing these relationships and the important information that can be obtained from these financial statements, the investigator will be better prepared to prove motive, interview or interrogate witnesses and subjects and improve overall investigative skills.

Balance Sheet
XYZ Company
December 31, 1995
1995
____
1994
____
  1995
____
1994
____
Assets     Liabilities    
Current Assets     Current Liabilities    
Cash $ 8,000 $22,000 Accounts payable $ 42,500 $ 28,900
Prepaid Expenses 3,000 4,000 Notes payable 22,500 8,500
Marketable
Securities
5,000 8,000 Accrued expenses
payable
2,500 2,200
Accounts Receivable 14,000 10,000 Federal income tax
payable
2,880 2,880
Inventory 52,000
______
66,000
_______
     
TOTAL CURRENT ASSETS $ 82,000 $110,000 Long term liabilities $ 69,120
________
$ 34,500
________
      TOTAL
LIABILITIES
$139,500 $76,980
Fixed Assets          
Plant $55,000 $55,000      
Equipment 38,000 18,000      
Land 20,000  20,000      
Office equiment 18,000 12,000
Less accumulated
depreciation (on all
Fixed Assets)
(36,000) (31,550)

Stockholders Equity

Capital Stock

_______ ________ Preferred stock $ 5,000 $ 5,000
Net Fixed Assets $ 55,000 $ 73,450 Common stock 10,000 10,000
      Capital surplus 1,000 18,000
Intangibles     Accumulated
retained earnings
1,500 93,470
 Goodwill $ 10,000 $ 10,000 ______ _______
Patents 5,000 5,000 Total stockholder's
equity
$17,500 $126,470
 Trademarks 5,000
_______
5,000
______
Total Assets $157,000 $203,450 Total liabilities and
stockholder's
equity
$157,000 $203,450

Figure 1


Consolidated Income
Statement
XYZ Company
  1995
1994
Net sales $23,000 $99,200
Less cost of sales and operating expenses
Cost of goods sold 45,000 28,000
 Depreciation 4,450 4,800
Selling and admin.
expenses
63,670
_______
5,800
_____
Operating profit (90,120) 60,600
Plus other income    
Dividends and interest 500 1,200
  ________  _______
TOTAL INCOME (89,620) 61,800
     
Less interest on bonds 1,350 3,600
     
Provision for federal income tax 0
_________
42,000
_______
NET PROFIT (LOSS) FOR YEAR <90,970> 54,000

Figure 2


Ratio Analysis for XYZ Company
  1995 1994

Current Ratio =

Current Assets
____________

Current Liabilities

82,000 = .59
___________

139,500

110,000 = 1.43
____________

76,980

Net Worth =
Assets - Liabilities
157,000 - 139,500 = 17,500 203,450 - 76,980 = 126,470
Working Capital =
Current Assets - Current Liabilities
82,000 - 139,500 = <57,500> 110,000 - 76,980 = 33,020

Acid Test Ratio =

(Cash + Accounts Receivable + Marketable Securities)
_______________________

Current Liabilities

(8,000 + 14,000 + 5,000) = .19
_________________________

(139,500)

(22,000 + 10,000 + 8,000) = .52
_______________________

(76,980) 

Quick Assets - Current Assets = Inventory 82,000 - 52,000 = 30,000  110,000 - 66,000 = 44,000
Net Quick Assets =
Quick Assets - Current Liabilities
30,000 - 139,500 = <109,500> 44,000 - 33,020 = 10,980
Ratio analysis in the above example shows a very drastic change in financial condition of the company from 1994 to 1995. The company had nearly 1.5 times more assets than liabilities and now has twice as many liabilities as assets. The company's net worth decreased over 100,000, its working capital is at a deficit, and the acid test and related measures show the company is in deep financial trouble, especially when examining Net Quick Assets. When the Income Statement is analyzed, it substantiates these findings by showing a huge loss in 1995.

Figure 3

The first financial statement to understand and analyze is the most common of all financial statements--the Balance Sheet. The Balance Sheet is a "snapshot" of the financial condition of the business at a given point in time. This financial picture can drastically change the next day or the next week. In order to understand the Balance Sheet, one should understand its key categories: current assets, fixed assets, depreciation and current liabilities.

Current assets are those assets that are expected to be converted into cash in one year or less. Cash is the money on hand in the petty cash fund as well as money in bank accounts. Marketable securities are investments of "idle cash" or excess cash that can be liquidated instantly to pay for current liabilities and other emergency needs. Accounts receivables represent the value of goods and/or services sold on account to a consumer. Normally the consumer is-given 30, 60, or 90 days to make payment. These receivables are receipts expected to be paid, however, to show a realistic figure, net accounts receivables need to be calculated. Sometimes; sales are made and the items are returned, negating the actual sale. Sometimes (hopefully not often), the sales, and thus accounts receivables, are not expected to be paid by the consumer for any number of reasons. An allowance for uncollectible accounts receivables is subtracted from the actual accounts receivables to arrive at the net accounts receivables. The investigator must watch for a high return of sales items as well as a high percentage of uncollectible accounts. This could be due to poor management, poor credit to risky consumers or "buying" the merchandise just prior to the fire loss.

Fixed assets are assets that are not for intended sale to the consumer yet are needed in the day-to-day operation of the business. Generally, these assets are of high value and tend to have an estimated useful life. This useful life is designed to take into account the wear and tear of the asset over time. The business owner is allowed to spread the cost of these assets over the useful life of the asset by the use of depreciation. The Income Statement shows depreciation of fixed assets for the year, while the Balance Sheet shows the accumulated depreciation from the time the assets were acquired until the assets are fully depreciated.

Another current asset is prepaid expenses, which are advance payments of funds where the business has not yet received benefits but will receive benefits within the year. Examples of prepaid expenses include prepaid insurance, prepaid advertising and prepaid rent. The investigator must examine the trend of these payments and note any change in the way these accounts are handled. For example, if a business has never made prepayments for insurance and generally has paid insurance premiums on a monthly, quarterly or yearly basis since being in operation, yet two months before the fire loss reverted to prepaid insurance payments, it is possible that the business owner wanted to make sure that his insurance would be in effect when the fire loss was incurred.

Current liabilities represent the debt that is owed and payable by the business in 12 months or less.

Long-term liabilities represent the debt that is owed by the business, payable in 12 months or more.

Depreciation is the periodic cost of an asset that expires over the life of that asset. There are several methods of calculating and declaring depreciation. The most common methods are:

(a) Straight Line Depreciation (SLD)

(b) Double Declining Balance (DDB)

(c) Sum of Years Digits (SOYD)

(d) Production Method (PROD)

The production method is geared to the actual usage rate of the asset. For example, if a vehicle is deemed to have a useful life of 5 years or 100,000 miles, the production method would utilize the actual mileage driven that year and apply the proportionate depreciation equivalent to that use. Because these calculations depend on each firm's specific example, I will deal with the other three common ways of determining depreciation.

Because depreciation is a source of funds, it creates cash flow. The more depreciation that exists, the higher the cash flow.

An example of how the depreciation method affects the financial picture of the company is illustrated below. Assume that a company purchases a truck for $20,000, and the truck has a useful life of 5 years. At the end of the life of the vehicle, the truck has no salvage value.

Straight line depreciation (SLD) takes equal values of depreciation over the life of the asset. In the following example, the SLD method is calculated at 20% of the amount to be depreciated each year over the life of the asset.

The most common methods

Straight Line Depreciation (SLD)

Cost = $20,000
Residual Value = none
n = 5 years
Depreciation = (Initial Cost - Residual Value) / Useful Life

Year (Income Statement)
Depreciation Expense
(Balance Sheet)
Accumulated Depreciation
0 0 0
1 $ 4,000 $ 4,000
2 $ 4,000 $ 8,000
3 $ 4,000 $12,000
4 $ 4,000 $16,000
5 $ 4,000
_______
$20,000
  $20,000  

Double declining balance (DDB) is an accelerated depreciation method which calculates depreciation at twice the rate as straight line depreciation. Because the SLD example above was depreciated at a rate of 20% each year over the five year life of the asset, the DDB method depreciates the remaining balance each year at the rate of 40%.

Double Declining Balance (DDB)

Cost = $20,000
Residual Value = none
n = 5 years
Depreciation =

(Initial Cost - Residual Value) x 2 x Remaining Balance
________________________________________________

Useful Life

Year (Income Statement)
Depreciation
Expense
(Balance Sheet)
Accumulated
Depreciation
Balance
0 0 $20,000
1 $ 8,000 $ 8,000 $12,000
2 $ 4,800 $12,800 $ 7,200
3 $ 2,800 $15,680 $ 4,320
4 $ 1,728 $17,408 $ 2,592
5 $ 2,592 $20,000 $ 0

Sum of years digits method of depreciation is another accelerated depreciation method for periodic decrease in the depreciation of the asset over time with the majority of the depreciation coming early in the life of the asset.

Sum of Years Digits (SOUD)

Cost = $20,000
Residual Value = none
n = 5 years
Depreciation =
(Year in Reverse Order / Sum of Useful Years) x Amount to be Depreciated

Year Factor (Income Statement) Depreciation Expense (Balance Sheet) Accumulated Depreciation Balance
0 0 0 0 $20,000
1 5/15 $ 6,667 $ 6,667  $13,333
2 4/15 $ 5,333 $12,000 $ 8,000
3 3/15 $ 4,000 $16,000 $ 4,000
4 2/15 $ 2,667 $18,667 $ 1,333
5 1/15
____
$ 1,333
______
$20,000 $ 0
  1.0  $20,000    

Results of the different methods of depreciation are combined in the table below to illustrate the differences that can be listed on the depreciation and accumulated depreciation figures present on the Income Statement and Balance Sheet, respectively.

Depreciation Method Comparison
Year SLD DDB SOYD
0 0 0
1 4,000 8,000 6,667
2 4,000 4,800 5,333
3 4,000 2,880 4,000
4 4,000 1,728 2,667
5 4,000
______
2,592
_______
1,333
_______
Totals 20,000 20,000 20,000

There are marked differences in each of the methods of depreciation which are generally outlined below.

Advantages Disadvantages
SLD  
Easy to calculate. Does not represent actual use of most long-term tangible assets.
DDB  
Provides a truer picture of use for most long-term tangible assets than SLD does. Harder to calculate than SLD method.
Accelerates depreciation at a faster rate in the early years of the life of the asset to offset cash flow problems that may exist. In the latter years less depreciation exists to offset income.
SOYD  
Provides a truer picture of use for most long- term tangible assets than SLD method. Easier to calculate than DDB method.
Accelerates depreciation at a faster rate in the early years of the life of the asset to offset cash flow problems that may exist. In the latter years less depreciation exists to offset income.

A comparative analysis should be conducted on all the Balance Sheets, Income Statements and other financial statements, particularly the last three to five years, to show trends and sudden changes in the business. This can be accomplished by ratio analysis of the financial statements. Ratio analysis can be defined as the comparison of a certain category amount on a particular statement as compared to the same category amount on another period's statement. Like ratios can then be compared from year to year to see the company's trends, strengths, solvency, earning power and growth potential.

In order to understand and apply ratio analysis to the arson for profit investigation, one must understand the different types of ratios and equations that are available and how they are related to the financial condition and subsequent changes in the business over time. One of the most important relationships to be analyzed is solvency.

Solvency is the ability to meet financial obligations as they become due. Solvency analysis focuses primarily on Balance Sheet relationships that indicate the ability to liquidate current and non-current liabilities. The major areas of analysis utilized in assessing solvency include:

(1) Current position analysis

(2) Account receivable analysis

(3) Merchandise inventory analysis

(4) Ratio of plant assets to long term liabilities

(5) Ratio of stockholders' equity to liabilities

CURRENT POSITION ANALYSIS

To be useful, ratios relating to solvency must indicate the individual or firm's ability to liquidate liabilities. These ratios are of great interest to short- term creditors. Ratios and equations that relate to the solvency position of an individual or company include the following:

(1) Net Worth = Assets less Liabilities. This formula determines if the business has more assets than what is owed.

(2) Working Capital = Current Assets less Current Liabilities. This formula is used to determine the ability to meet current maturing obligations. To determine if a company is growing, the working capital should tend to increase each year.

(3) Current Ratio = Current Assets/Current Liabilities. This formula is sometimes referred to as "working capital ratio" or "banker's ratio." The Current Ratio is a more dependable indicator of solvency than the Net Worth Ratio or the Working Capital Ratio. A normal Current Ratio should be approximately 2:1, depending on the industry. This means that the business should have twice as many assets as liabilities. Should this ratio be reversed, it means that the business has twice as many bills as it is capable of paying at the present time.

(4) Acid-Test Ratio. This ratio is the sum of cash, accounts receivables and marketable securities [sometimes called "quick assets"] compared to current liabilities. The amount of Working Capital and the Current Ratio are two solvency measures that indicate a company's or individual's ability to meet current maturing obligations. However, these two analyses do not take into account the actual make-up or composition of the current assets. The Quick Assets Ratio is then used to measure the instant debt-paying ability of an individual or company.

(5) Quick Assets = Current Assets less Inventories. This formula represents the ability of the business to quickly convert inventory into cash and meet any financial emergency as it becomes due. As a result, this analysis is a good indicator of the firm's ability to also meet its obligations.

(6) Net Quick Assets = Quick Assets less Current Liabilities. This formula represents the ability of the business to meet its current obligations without having to sell merchandise inventory. This is a good indicator of the firm's ability to met its current obligations without having to sell off the inventory.

(7) Quick Assets Ratio = Quick Assets/Current Liabilities. This is a ratio that measures the ability of the business to pay off its current obligations in the current position of the firm.

$1,950,000 in Quick Assets
________________________

$985,000 in Current Liabilities

= 1.98

In the above example, for every dollar of current liabilities that exists there is $1.98 of quick assets to cover those liabilities. If this figure nears 1.0 or less, the firm will have difficulty in meeting its current obligations without taking further action.

ACCOUNTS RECEIVABLE ANALYSIS

The size, amounts and composition of accounts receivables is constantly changing during business operations. Total accounts receivables are increased by sales and decreased by collections or write-offs. An entity that has long-term credit terms tends to have more accounts receivables tied up and unavailable for use than entities with short-term credit terms. An increase or decrease in the dollar amount of sales has a direct bearing on the outstanding accounts receivables. Because accounts receivables yield no revenue, it is a good business practice to keep the amount invested in accounts receivables at a minimum. Some of the ratios utilized in accounts receivable analysis are:

(1) Accounts Receivable Turnover

This is the relationship between credit sales and accounts receivables. Accounts Receivable Turnover is calculated by dividing net sales on account (sales less returnables) by the average net accounts receivables. The changes in accounts receivable turnover ratios is indicative of the acceleration in the collection of receivables, due perhaps to an improvement in either the granting of credit or collection practices or both.

(2) Number of Days Sales in Receivables

This is another way to express the relationship between credit sales and accounts receivables. The number of days sales in receivables is determined by dividing the net accounts receivables at the end of the year by the average daily sales on account (net sales on account divided by 365 days). For example:

  1995 1994
Accounts receivables
(net, end of year)
150,000 98,000
Net sales on account 850,000 825,000
Average daily sales on account 2,329 2,260
Number of day's sales in receivables 64.4 43.4

The number of days' sales in accounts receivables provides a measure of the length of time the accounts receivables have been outstanding. This equates to the business financing a customer for not paying the amount owed to the business. It lowers cash and decreases the business' ability to meet current financial obligations as they become due. In this case, the business has decreased the efficiency of collecting receivables and shows a trend to having cash flow problems by having an increase of three weeks (21 days) in collecting receivables as compared to the previous year.

MERCHANDISE INVENTORY ANALYSIS

Merchandise inventory analysis is best analyzed by examining both Merchandise Inventory Turnover and the Number of Days Sales in Inventories.

Merchandise Inventory Turnover is the relationship between the volume of merchandise sold and the merchandise inventory. It is computed by dividing the cost of the merchandise sold by the average inventory. It is understood that a business must have a sufficient amount of inventory available to sell to meet the demands of the consumer and to generate revenue. However, it is desirable to keep the amount of money invested in inventory at a minimum and maintain control of that inventory. Increases in inventory contribute to increases in insurance, property and inventory taxes, storage costs, and other related costs of maintaining that inventory. The increase in inventory either depletes the cash on hand or increases the current liabilities in the form of accounts payable. This has a definite effect on the solvency of the business, especially when the inventory is outdated, out of style, spoiled or when sales are slow. For example:

  1995 1994
Cost of merchandise sold 400,000 500,000

Merchandise inventory:

Beginning of year
End of year

Total

 


110,000
135,000
________
245,000

 


105,000
98,000
________
203,000

Average 122,500 101,500
Merchandise Inventory Turnover 3.26 4.9

In this example, the turnover rate for 1994 is much higher than the turnover rate for 1995. This could be an indication that sales are slower for whatever reason and certainly that the cost of maintaining inventory has increased.

Number of Days Sales in Inventories is the relationship between the cost of the merchandise sold and the merchandise inventory. This is calculated by dividing the merchandise inventory at the end of the year by the average daily cost of merchandise sold (cost of the merchandise sold divided by 365 days), as illustrated below:

  1995 1994
Merchandise inventory
(End of year)
295,000 215,000
Net sales on account 635,000 745,000
Average daily sales on account 1,740 2,041
Number of day's sales in receivables 170 105

The number of days sales in inventory provides an estimate of the length of time it takes a business to acquire, sell and subsequently replace the average merchandise inventory. This is a basis for determining the company's ability to have effective inventory control. In this example, the number of days sales in inventory has increased over 60 days from 1994 to 1995. This may be a significant number to finance an extra two months if other cash flow problems exist.

RATIO OF PLANT ASSETS TO LONG TERM LIABILITIES

Long term notes and sometimes bonds are frequently secured by mortgages on plant assets. Therefore, the ratio of plant assets to long term liabilities is important, because it provides a measurement that indicates the risk or margin of safety of the holders of these notes or bonds. The strength of this ratio also provides an indication for the potential ability of the company to borrow any additional funds that are needed on a long term basis.

  1995 1994
Plant assets (net) 300,000 195,000
Long term liabilities 250,000 95,000
Ratio of plant assets to long term liabilities 1.2 2.05

The decrease in this ratio is attributable to the company's sharp increase in long term liabilities. The investigator must closely examine the reason for this increase to determine if the company has over-extended its potential ability to pay back these liabilities over the long term.

RATIO OF STOCKHOLDERS EQUITY TO LIABILITIES

Any claims that can be made against the total assets of the company are made by either the creditors or the owners of the business. The relationship between the creditors (liabilities) and the owners (stockholders equity) provides a measure of risk and the measure of the ability of the company to withstand adverse business conditions of any kind. The ratio of stockholders equity to liabilities, for example:

  1995 1994
Total stockholder's equity 350,000 625,000
Long term liabilities 250,000 95,000
Ratio of plant assets to long term liabilities 1.4 6.58

If the claims of the creditors are larger in proportion to the claims of the stockholders, there is likely to be substantial interest payments that must be made. If earnings decline to the point that these interest payments and other liabilities cannot be met, control of the business may revert to the creditors. In this case, the sharp increase in long term liabilities and the substantial decrease in stockholder's equity provides a very poor margin of safety for creditors.

There are several factors that could be scrutinized in detail if the financial picture of the company looks somewhat bleak or suspicious. Some of these categories include an in-depth look at the way the company places a value on their inventory. These inventory valuations could consist of the following common methods:

(a) LIFO - Last In First Out

(b) FIFO - First In First Out

(c) Average costing method

(d) Cost or Market

Each of these methods could inflate or deflate certain figures on the Balance Sheet and Income Statement, depending on the method used.

In conclusion, these key red flags in financial statement analysis are critical in assessing the financial condition of a business in arson for profit investigations. If the investigator realizes that any net worth increases represent income, expenditures represent additional income and any increase of net worth, plus expenditures equates to income, the investigator can perform additional calculations that shed light on the investigation and/or financial motive. Knowing that income less any legitimate income equates to unexplained income, the investigator can challenge the financial statements and supporting documents (or lack thereof). If these records have been destroyed or "lost" in the fire, the investigator must be able to reconstruct the financial statements and the condition of the business through numerous means, including contacting creditors, suppliers, accountants, bookkeepers, current and former employees, and obtaining bank records, canceled checks and the like to come up with a financial picture of the business.

About the Author

Douglas O. Crewse received his B.S. degree in Applied Science and Engineering from the United States Military Academy at West Point and an MBA from Texas Tech University. He is a Certified Fraud Examiner and a former Special Agent Commander with the U.S. Air Force Office (OSI). He has taught continuing education courses for local, state and federal law enforcement, private investigators and corporate professionals for more than ten years.

Reprinted with permission.

 
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