What Red Flags Are Associated with Financial Statement Fraud in General?
Red flags associated with particular financial statement fraud schemes have been discussed previously. There are many red flags associated with financial statement fraud generally. An extensive list of such red flags can be found in an appendix to ISA 240, 240, The Auditor’s Responsibility Relating to Fraud in an Audit of Financial Statements, where they are called “fraud risk factors.” Some red flags indicate increased vulnerability to financial statement fraud; others indicate a greater likelihood that financial statement fraud has occurred.
Some of the more significant red flags are:
- Domination of management by a single person or small group (in a nonowner-managed business) without compensating controls
- Profitability or trend level expectations of investment analysts, institutional investors, significant creditors, or other external parties (particularly expectations that are unduly aggressive or unrealistic), including expectations created by management in, for example, overly optimistic press releases or annual report messages
- Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management or the communication of inappropriate values or ethical standards
- Recurring negative cash flows from operations or an inability to generate positive cash flows from operations while reporting earnings and earnings growth
- Rapid growth or unusual profitability, especially compared to that of other companies in the same industry
- Significant, unusual, or highly complex transactions, especially those close to a period’s end that pose difficult “substance over form” questions
- Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm
- Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality
- Formal or informal restrictions on the auditor that inappropriately limit access to people or information, or limit the ability of the auditor to communicate effectively with those charged with governance
To better understand basic accounting concepts and to see how an analysis of accounting records and procedures can reveal a fraud, consider the following example:
Jackson Hardware Supply is a medium-sized plumbing and electrical wholesale distributor. On 31 December, the statement of financial position and statement of profit or loss and other comprehensive income were as follows:
An anonymous tip was received that the paymaster, a long-time trusted employee, is stealing cash from the company. Lately, he has been seen driving a new BMW and has gone on expensive holidays. The president of the company wants to follow up on the tip and asks the fraud examiner to determine if the paymaster has been stealing. Although there are several ways to proceed with the investigation, the fraud examiner with accounting knowledge decides to first compare this year’s total salary expense with last year’s balance. He theorises that if the paymaster is dishonest, he might be concealing the theft in the salaries expense account. Past experience has taught the fraud examiner to look in the most obvious place first.
The fraud examiner notes that the balance of $220,000 in the salary expense account this year is significantly larger than the $180,000 balance last year. He asks the owner if there was an increase in the number of employees and how large across-the-board raises were this year. He discovers that the workforce did not increase and all employees, including the owner, received 10 percent raises. He recalculates this year’s salaries by increasing last year’s salaries 10 percent and determines that the balance in the salary expense account should be approximately $198,000 ($180,000 x 1.10 = $198,000). He now believes that excess salaries went to someone.
The next step is to follow the overstatement in salary expense backward from the statement of profit or loss and other comprehensive income through the accounts and journal entries to the source documents—the payroll cheques in this case. He finds that there are 12 cheques payable to John Doe, an employee who quit in January of last year. He compares the endorsements on John Doe’s cheques with those on the paymaster’s cheques and notices distinct similarities in the signatures. Armed with this evidence, he interviews the paymaster who confesses that he has stolen $22,000 and concealed the theft by issuing payroll cheques to a nonexistent employee, cheques that he subsequently endorsed and cashed.
Obviously, this example is relatively simple; but most fraud schemes are simple, especially for a fraud examiner who understands concealment techniques and accounting concepts.
Other detection techniques are available for determining if the paymaster is stealing. These include running a report of all employees who do not elect insurance coverage and other payroll withholdings (withholdings on fictitious employees create additional concealment problems for perpetrators), having someone else distribute the cheques, and examining identification numbers of all active employees. Any of these methods might have revealed the bogus pay cheques to John Doe. The approach shows, however, how an understanding of accounting can be invaluable for detecting fraud.