Fraud Analyzed through the Gross Margin Ratio

The gross margin ratio is a financial ratio that mainly deals with a company’s ability to purchase goods at a reasonable price and sell them for an even greater price to achieve are large margin or profit on the sale. The basic gross profit calculation is equated by subtracting gross sales from the cost of goods sold.

Not all businesses choose to account for the margins properly. Some companies choose to omit, hide, or even distort their financial performance in order to mislead investors and creditors. This form of financial shenanigans is exactly what caused the fraud cases in the early 2000s.

Some companies, like Enron, use creative accounting techniques to disguise earnings and distort their gross margin ratios to lure investors in and create an artificially high stock price. This not only provides a warped view of the company’s performance (ie their gross margin ratio), it also distorts the view of the financial health of the company.

Companies usually attempt financial reporting fraud in a few different ways by:

  1. Reporting earnings in incorrect periods
  2. Reporting fictitious earnings
  3. Recording one time events as earnings
  4. Delaying expenses until future years
  5. Creating off balance sheet liabilities
  6. Reporting current earnings in future periods and future expenses in current periods

All of these accounting shenanigans are designed to manipulate a company’s financial reporting in order to deceive investors, creditors, or even the public at large.

Extra Resources:
Gross margin ratios and explanations