DETECTING RED FLAGS

The red flags of financial statement fraud are distinctly different from those of asset misappropriation, according to White Collar Crime Fighter Newsletter. Common red flags of financial statement fraud are as follows:

• Accounting anomalies;
• Unusually rapid revenue and/or profit growth;
• Readily noticeable internal control weaknesses;
• Noticeably “aggressive” financial actions by senior management; and
• Personality or character flaws of the CEO and/or other “C-level” executives.

Of these general indicators, top management personality and character flaws are by far the most compelling red flags with regard to financial statement fraud. Typically, a senior executive who is inclined to “cook the books” possesses low ethical standards, though this trait may often be difficult to detect prior to the commission of a crime. Most executives with ethical weaknesses also exhibit very noticeable signs of aggressiveness in almost everything they do—including making critical financial decisions.

They may:

• Be overly domineering, disrespectful, or have an abusive management style with subordinates;
• Actively “steer” internal and external auditors away from financial reports that could reveal the fraud; or
• Demonstrate a secretive or evasive attitude regarding critical financial information.

Here are some ways that general financial statement fraud can be detected:

• Internal audit is consistently engaged in substantive anti-fraud activities.
• Auditors aggressively apply standards of SAS No. 99.
• Frequent and thorough fraud-oriented ratio analysis is conducted—focusing in particular on long-term trends and on comparisons between business units.
• Surprise audits and/or cash counts are conducted.
• An anonymous, user-friendly tip hotline is implemented for use by employees, vendors, and customers.
• Data mining is undertaken, using one of the common auditing software applications such as ACL or IDEA.

FRAUD CATEGORIES

There are distinct categories of financial statement fraud. Each has its unique red flags and detection methods. Some examples follow:¹

Revenue recognition or timing schemes. This is also known as improper treatment of sales. This fraud category is possibly the most common form of financial statement fraud. It is usually employed when management seeks to conceal the real numbers for a weak quarter or two. Red flags include:

• If a sale is legitimate, but is posted prematurely, the red flag would be a GAAP violation by early recording of the sale.
• Similarly, channel stuffing—where sales are recorded before they’ve actually been made—would be indicated by an excessive number of subsequent period returns of merchandise, accompanied by an unusual jump in credits.

Fictitious revenue. This is one of the oldest financial statement schemes around. It involves posting sales that never occurred. Red flags include:

• Unusual increase in assets—the other side of the entry to mask fictitious revenues;
• Customer records are missing key data such as physical address and phone number; and
• Unusual changes in ratio patterns—such as a spike in revenues with no commensurate increase in accounts receivable.

Concealed liabilities (improper or under-reporting of expenses and other liabilities). This fraud is committed by shifting expenses from one entity to another or reclassifying liabilities as assets. Red flags include:

• Use of different audit firms for different subsidiaries or business entities;
• Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings growth;
• Invoices and other liabilities go unrecorded in the company’s financial records;
• Loans to executives or other parties are written off; and
• Warranty-related liabilities are not recorded.

Inadequate disclosures. This tactic is used after a financial statement fraud has occurred—in an attempt to cover it up. Red flags include:

• Disclosure notes are so complex that it is impossible to determine the actual nature of the event or transaction; and
• Undisclosed legal contingencies are discovered.

Improper asset valuation. A common form of profit manipulation is the practice of fraudulently inflating asset valuations. Red flags include:

• Unusual or unexplained increases in the book value of assets such as inventory, receivables, or long-term assets;
• Odd patterns in relationships of assets to other components of the financial report, such as sudden changes in the ratio of receivables to revenues; and
• GAAP violations in recording expenses as assets.