fraud red flags

7/30/2019 Fraud Red Flags

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Fraud Red Flags

This tool provides opportunity red flags, personal characteristic red

flags, and situational pressure red flags of possible fraudulent activity.

It also provides indicators of possible fraudulent activity for various

business processes including accounts payable process, purchasing

process, payroll process, cash receipts process, accounts receivable

process, inventory/production process, and finance process.

1. Opportunity Red Flags

a. Fraud Conducted By Employees Against The Company

Familiarity with operations (including cover-up capabilities and

in a position of trust)

Close association with suppliers and other key people

A firm that does not inform employees about the rules or the

action taken to combat fraud

Rapid turnover of key employees either by quitting or firing

No mandatory vacations, periodic rotations, or transfers of key

employees

Inadequate personnel-screening policies when hiring new

employees to fill positions of trust

An absence of explicit and uniform personnel policies

No maintenance of accurate personnel records of dishonest acts

or disciplinary actions

Executive disclosures and examinations not required

A dishonest or overly dominant management

Operating on a crisis basis

No attention paid to details

Unrealistic productivity measurements

Poor compensation practices

A lack of internal security

Inadequate training programs

b. Fraud Conducted By Individuals On Behalf Of The Company

Related party transactions

A complex business structure

No effective internal auditing staff


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A highly computerized firm

A firm in atypical or "hot" industries

A firm that uses several different auditing firms or changes

auditors often

A firm that is reluctant to give auditors needed data

A firm that uses several different legal firms or changes legal

counsels often

A firm that uses an unusually large number of different banks,

none of which can see the entire picture

Continuous problems with various regulatory agencies

Large year-end and/or unusual transactions

An inadequate internal control system or no enforcement of the

existing internal controls

Unduly liberal accounting practices Poor accounting records and inadequate staffing in the

accounting department

A firm that inadequately discloses questionable or unusual

accounting practices

c. Some circumstances that might contribute to fraud include:

Weak internal control environment

Management does not emphasize the role of strong internal

controls Management does not prosecute or punish identified

embezzlers

Management does not have a clear position about conflicts of

interest

Highly placed executives are less than prudent or restrained on

expenditures for travel and entertainment, furnishings of

offices, gifts to visitors and directors, etc.

Internal auditing does not have authority to investigate certain

executive activities involving heavy personal expenditures Accounting policies and procedures are on the lax or loose side

2. Personal Characteristic Red Flags

Warning Signals Should Go Off When Employees Evidence

Characteristics Such As:

Rationalization of contradictory behavior


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Lack of a strong code of personal ethics

A wheeler-dealer personality

Lack of stability

A strong desire to beat the system

A criminal or questionable background A poor credit rating and financial status

3. Situational Pressure Red Flags

Fraud Committed By Employees Against The Company

Significant observed changes from past behavior patterns

High personal debts or financial losses

Inadequate income for lifestyle

Extensive stock market or other speculation behavior

Excessive gambling

Undue family, company, or community expectations

Excessive use of alcohol or drugs

Perceived inequities in the organization

Resentment of superiors and frustration with job

Peer group pressures

Undue desire for self-enrichment and personal gain

Emotional trauma in home life or work life

Fraud Committed By Management On Behalf Of The Company

Unfavorable economic conditions within the industry

Insufficient working capital

Dependence on one or two products customers or transactions

Severe obsolescence

High debt

Extremely rapid expansion through new business or product

lines

Reduced ability to acquire credit or restrictive loan agreements Profit squeeze; costs and expenses rising higher and faster than

sales and revenues

Difficulty in collecting receivables

Progressive deterioration in quality of earnings

Significant tax adjustments


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Managers who regularly assume subordinates duties

Noncompliance with corporate directives and procedures

Managers dealing in matters outside their profit center's scope

Payments to trade creditors supported by copies instead of

originals Negative debit memos

Commissions not in line with increased sales

Telltale Signs of Management and Corporate Fraud

In every case of management and corporate fraud telltale signs of

the fraud exist for some period of time before a third party detects

or discloses it. These signs may be

1)Significant observed changes from the defrauder's past

behavior patterns2)Knowledge that the defrauder was undergoing emotional

trauma in his home life or work life

3)Knowledge that the defrauder was betting heavily, drinking

heavily, had a very expensive social life, or was sexually

promiscuous

4)Knowledge that the defrauder was heavily in debt

5)Audit findings deemed to be errors and irregularities that were

considered immaterial at the time

6)Knowledge that the company was having financial difficulties

such as frequent cash flow shortages, declining sales and/orprofits, and loss of market share

7)Knowledge that management was showing increasing signs of

incompetence, i.e., poor planning, organization communications

controls, motivation, and delegation, management indecision

and confusion about corporate mission, goals, and strategies,

and management ignorance of conditions in the industry and in

the general economy

8)Substantial growth beyond the industry norm versus regulated

industries

4. Characteristics of Top Management Fraud

Top Management Defrauders

Tend to have highly material personal values.

Success to them means financial success, not professional

recognition.


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Tend to treat people as objects, not individuals and often as

objects for exploitation.

Are highly self-centered.

Are often eccentric in the way they display their wealth or

spend their money. They tend to be conspicuous consumers and often boast of the

things they have acquired, the friends they have in high office,

and all the fine places they have visited.

Speak about their cunning achievements and winnings more

than their losses.

Appear to be reckless or careless with facts and often enlarge

on them.

Appear to be hard working, almost compulsive, but most of

their time at work is spent scheming and designing short cuts toget ahead or beat the competition.

Manage by crisis more often than by objectives.

Tend to drift with the times and have no long-range plans, tend

to override internal controls with impunity and argue forcefully

for less formality in controls.

Demand absolute loyalty from subordinates, but they

themselves are loyal only to their own self-interests.

Have few real friends within their own industry or company.

Their competitors and colleagues often dislike them.

5. Indicators of Possible Fraudulent Activities

1)Transactions that are odd as to:

Time (of day, week, month, year, or season), Frequency (too

many, too few), Places (too far &, too near, and too "Far out"),

Amount (too high, too low, too consistent, too alike, too

different), Parties or personalities (related parties, oddball

personalities, strange and estranged relationships between

parties, management performing clerical functions).

Internal controls that are unenforced or too often compromised

by higher authorities

2)Employee motivation, morale and job satisfaction levels that are

chronically low

3)A corporate culture and reward system that supports unethical

behavior toward employees, customers, competitors, lenders, and


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shareholders

Examples of fraud risk indicators that might be noted during

fieldwork are:

Discrepancies in Accounting Records

Account balances that are significantly over or understated

Transactions not recorded in a complete or timely manner or

improperly recorded as to amount, accounting period,

classification, or company policy

Unsupported or unauthorized records, balances, or

transactions

Last minute client adjustments that significantly affect

financial results (particularly those increasing income

presented after submission of the proposed audit adjustments)

6. Understanding Symptoms/Red Flags of Fraud

Understanding symptoms of fraud is the key to detecting fraud. A

symptom of fraud may be defined as a condition which is directly

attributable to dishonest or fraudulent activity. It may result from the

fraud itself or from the attempt to conceal the fraud.

The following are representative examples of symptoms or red flags of

fraud:

1) Accounts Payable Process

Recurring identical amounts from the same vendor.

Unusual even dollar or high cash disbursement amounts forroutine odd dollar or low value purchase.

Multiple remittance addresses for the same vendor.

Vendor addresses do not agree with vendor approval

application.

Sequential invoice numbers from the same vendor or invoice

numbers with an alpha suffix.

Payments to vendor have increased dramatically for no

apparent reason. slow or no payments not justified by

disbursement schedule.2) Purchasing Process

Turnover among buyers within the purchasing department

significantly exceeds attrition rates throughout the

organization.

Purchase order proficiency rates fluctuate significantly among

buyers within comparable workload levels.


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Dramatic increase in purchase volume per certain vendor(s)

not justified by competitive bidding or changes in production

specifications.

Unaccounted purchase order numbers or physical loss of

purchase orders. Rise in the cost of routine purchases beyond the inflation rate.

Unusual purchases not consistent with the categories

identified by prior trends or operating budget.

3) Payroll Process

Dramatic increase in labor force or overtime not justified by

production or sales volume.

Turnover within the payroll department significantly exceeds

attrition rates throughout the organization.

Missing or easy access to blank checks, facsimile, and manual

check preparation machine.

Tax deposits are substantially less than those required by

current payroll expenses.

High volume of manually prepared payroll checks.

4) Cash Receipts Process

Improper safeguarding of cash under lock and key.

No segregation of duties between the following:

Receiving cash and posting to customer accounts

Issuing receipts and deposit preparation

Infrequent bank deposits, allowing cash to accumulate.

Consistent shortages in cash on hand.

Consistent fluctuations in bank account balances.

Closing out cash drawer before end of shift.

Excessive number of voided transactions on a regular basis

without proper explanation.

Missing copies of pre-numbered receipts. Not balancing cash to accounts receivable subledger.

Insufficient supervisory review of cashier's daily activity.

5) Accounts Receivable Process

Lack of accountability for invoice numbers issued.

Lack of segregation of duties between the following:


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Processing of accounts receivable invoices and posting to

subledger

Posting to accounts receivable subledger and cash receipts

Lack of policies and procedures regarding write-offs to satisfy

industry standards. Frequent undocumented and/or unapproved adjustments,

credits, and write- offs to accounts receivable subledger.

Low turnover or slow collection cycle for accounts receivable.

Dramatic increase in allowance for doubtful accounts in view of

positive economic events and stringent credit policies.

No reconciliation of accounts receivable subledger to general

ledger control account.

Insufficient supervisory review of accounts receivable activity

as well as customer account aging schedule. Unrestricted access to subledgers and general ledger.

6) Inventory/Production Process

Credit balances in inventory accounts.

Consistent fluctuations in inventory accounts between months

(e.g. debit balance one month, credit balance the next).

Excessive inventory write-offs without documentation or

approvals.

Unusual volume of adjustments, write-offs, and disposal ofmaterial, inventory, or fixed assets.

Unrestricted access to inventory storage areas by non-

responsible employees and/or vendors.

Significant weaknesses in inventory cut-off procedures.

No policy regarding identification, sale, and disposal of

obsolete and surplus materials.

Finished goods inventory turnover rate does not correlate with

operating cycle.

7) Finance Process Significant adjustments to accrued liabilities, accounts

receivable, contingencies, and other accounts prior to

acquisition of new financing.

Dramatic change in key leverage, operating, and profitability

ratios prior to obtaining financing.


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Adopting a change in accounting principle or revising an

accounting estimate prior to obtaining financing.

A delay in issuance of monthly, quarterly, or annual financial

reports prior to seeking new financing.

The Fraud Diamond: Considering the Four Elements of

Fraud

Despite intense efforts to stamp out corruption,

missappropriation of assets, and fraudulent financial reporting, it

appears that fraud in its various forms is a problem that is increasing in

frequency and severity. KPMGs Fraud Survey 2003 documented a

marked increase in overall fraud levels since its 1998 survey, with

employee fraud by far the most common type of fraud. The 2003

survey also noted that fraudulent financial reporting had more thandoubled from 1998. This trend is consistent with the unprecedented

recent spate of large accounting frauds (Enron, WorldCom), as well as

the increased number of accounting restatements and SEC

enforcement actions in recent years. (See 2003 Annual Review of

Financial Reporting Matters by the Huron Consulting Group and the

SECs Report Pursuant to Section 704 of the Sarbanes-Oxley Act of

2002.)

In response to the fraud problem, Congress and regulatory

authorities have enacted tougher laws and increased enforcementactions. Organizations are implementing tighter controls and broader

oversight. The auditing profession has adopted more rigorous auditing

standards and procedures, and software developers are adding

continuous monitoring features to back-office systems. It remains

unclear whether these efforts are sufficient to mitigate the fraud

problem.

Many studies suggest fraud is more likely to occur when

someone has an incentive (pressure) to commit fraud, weak controls or

oversight provide an opportunityfor the person to commit fraud, and

the person can rationalize the fraudulent behavior (attitude). Thisthree-pronged framework, commonly known as the fraud triangle,

has long been a useful tool for CPAs seeking to understand and

manage fraud risks. The framework has been formally adopted by the

auditing profession as part of SAS 99.

A Different Way to Think About Fraud Risks


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The fraud triangle could be enhanced to improve both fraud

prevention and detection by considering a fourth element. In addition

to addressing incentive, opportunity, and rationalization, the authors

four-sided fraud diamond also considers an individuals capability:

personal traits and abilities that play a major role in whether fraud may

actually occur even with the presence of the other three elements.

Many frauds, especially some of the multibillion-dollar ones, would not

have occurred without the right person with the right capabilities in

place. Opportunity opens the doorway to fraud, and incentive and

rationalization can draw the person toward it. But the person must

have the capability to recognize the open doorway as an opportunity

and to take advantage of it by walking through, not just once, but time

and time again. Accordingly, the critical question is, Who could turn

an opportunity for fraud into reality?

Using the four-element fraud diamond, a fraudsters thought

process might proceed as follow :

Incentive: I want to, or have a need to, commit fraud.

Opportunity: There is a weakness in the system that the right

person could exploit. Fraud is possible.

Rationalization: I have convinced myself that this fraudulent

behavior is worth the risks.

Capability: I have the necessary traits and abilities to be the right

person to pull it off. I have recognized this particular fraudopportunity and can turn it into reality.

While these four elements certainly overlap, the primary

contribution of the fraud diamond is that the capabilities to commit

fraud are explicitly and separately considered in the assessment of

fraud risk. By doing so, the fraud diamond moves beyond viewing fraud

opportunity largely in terms of environmental or situational factors, as

has been the practice under current and previous auditing standards.

For example, consider a company where the internal controls

allow the possibility that revenues could be recorded prematurely by

altering sales contract dates in the sales system. An opportunity for

fraud exists, if the right person is in place to understand and exploit it.

This opportunity for fraud becomes a much more serious problem if the

companys CEO, who is under intense pressure to increase sales, has

the technical skills to understand that the control weakness exists, can


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coerce the CFO and sales manager to manipulate the sales contract

dates, and can consistently lie to analysts and board members about

the companys growth. In the absence of such a CEO, the fraud

possibility would never become reality, despite the presence of the

elements of the fraud triangle. Thus, the CEOs capabilities are a major

factor in determining whether this control weakness will ultimately lead

to fraud.

The Person with Capability

Based on one authors experiences in investigating frauds for the

past 15 years, there are several essential traits for committing fraud,

especially for large sums or for a long period of time. First, the persons

position or function within the organization may furnish the ability to

create or exploit an opportunity for fraud not available to others. For

example, a CEO or divisional president has the positional authority toinfluence when contracts or deals take effect, thus affecting the timing

of revenue or expense recognition. Fraudulent Financial Reporting:

19871997, An Analysis of U.S. Public Companies (Beasley et al., 1999)

found that corporate CEOs were implicated in over 70% of public-

company accounting frauds, indicating that many organizations do not

implement sufficient checks and balances to mitigate the CEOs

capabilities to influence and perpetuate fraud. Additionally, when

people perform a certain function repeatedly, such as bank

reconciliations or setting up new vendor accounts, their capability to

commit fraud increases as their knowledge of the functions processes

and controls expands over time.

Second, the right person for a fraud is smart enough to

understand and exploit internal control weaknesses and to use

position, function, or authorized access to the greatest advantage.

Many of todays largest frauds are committed by intelligent,

experienced, creative people, with a solid grasp of company controls

and vulnerabilities. This knowledge is used to leverage the persons

responsibility over or authorized access to systems or assets.

According to the Association of Certified Fraud Examiners, 51% of theperpetrators of occupational fraud had at least a bachelors degree,

and 49% of the fraudsters were over 40 years old. In addition, 46% of

the frauds the Association recently studied were committed by

managers or executives.

Third, the right person has a strong ego and great confidence

that he will not be detected, or the person believes that he could easily


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talk himself out of trouble if caught. Such confidence or arrogance can

affect ones cost-benefit analysis of engaging in fraud; the more

confident the person, the lower the estimated cost of fraud will be. In

The Human Face of Fraud (CA Magazine, May 2003), R. Allan notes

that one of the common personality types among fraudsters is the

egotistsomeone who is driven to succeed at all costs, self-

absorbed, self-confident and narcissistic. Similarly, Duffield and

Grabosky (The Psychology of Fraud, Trends & Issues in Crime and

Criminal Justice, March 2001) note that, in addition to financial strain,

Another aspect of motivation that may apply to some or all types of

fraud is ego/power. The authors go on to quote Stotland (White

Collar Criminals, Journal of Social Issues, 1977) regarding ego: As

[fraudsters] found themselves successful at this crime, they began to

gain some secondary delight in the knowledge that they are fooling the

world, that they are showing their superiority to others.Fourth, a successful fraudster can coerce others to commit or

conceal fraud. A person with a very persuasive personality may be able

to convince others to go along with a fraud or to simply look the other

way. In addition, Allan notes that a common personality type among

fraudsters is the bully, who makes unusual and significant demands

of those who work for him or her, cultivates fear rather than respect

and consequently avoids being subject to the same rules and

procedures as others. Many financial reporting frauds are committed

by subordinates reacting to an edict from above to make your

numbers at all costs, or else.

Fifth, a successful fraudster lies effectively and consistently. To

avoid detection, she must look auditors, investors, and others right in

the eye and lie convincingly. She also possesses the skill to keep track

of the lies, so that the overall story remains consistent. In the Phar-Mor

fraud, the auditors claimed that Phar-Mor had formed a fraud team

of executives and former auditors who continually worked to hide

evidence about the fraud from them. The auditors claimed that the

fraud team lied, forged documents and scrubbed everything the

auditors saw to hide any indications of malfeasance. (See FindingAuditors Liable for Fraud: What the Jury Heard in the Phar-Mor Case,

Cottrell and Glover, The CPA Journal, July 1997.)

Finally, a successful fraudster deals very well with stress.

Committing a fraud and managing the fraud over a long period of time

can be extremely stressful. There is the risk of detection, with its

personal ramifications, as well as the constant need to conceal the


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fraud on a daily basis. Former HealthSouth CEO Richard Scrushy now

faces numerous criminal charges for allegedly masterminding a long-

running scheme to inflate the companys earnings during the terms of

several different CFOs. Despite the enormous pressure on him, Scrushy

has remained resolute during the course of the investigation, even

appearing on 60 Minutes to proclaim his innocence. In contrast, during

his sentencing, former HealthSouth Assistant Controller Emery Harris,

who allegedly was coerced to participate in the fraud, told the judge

how relieved he was after the company was raided by federal agents,

thinking it provided him the opportunity to finally get out of this

mess.

Dealing with Capability

Appreciating the importance of capability as a fourth element of

fraud is only part of the challenge. The next task is to addresscapability when assessing fraud risk, and to use knowledge about fraud

capability to prevent or detect fraud. Beyond considering incentive,

opportunity, and rationalization, the following steps could shed light on

capability.

Explicitly assess the capabilities of top executives and

key personnel. Focusing on capability requires organizations and

their auditors to better understand employees individual traits and

abilities. The audit committee member, corporate accountant, or

auditor should focus on the personality traits and skills of top

executives and others responsible for high-risk areas when assessing

fraud risk or seeking to prevent or detect fraud. Routine background

checks on new employees can identify past criminal convictions. In

assessing individuals traits and abilities, several methods of gathering

information may be helpful. First, there is no substitute for spending

time with a person. Frequent interaction under a variety of

circumstances, both business and social, can provide a meaningful

picture of the persons capabilities. Second, look for signals in the

little things. If the person cuts corners on small issues or consistently

displays an absolute refusal to lose or fail, no matter what the issue orthe cost, this may suggest similar behavior on larger issues. For

example, many have said that an executive who cheats in golf will

cheat in business. Finally, pay attention to what others say about a

person. If there are consistent statements about certain traits or

tendencies, this information can supplement more direct observations.

For example, if people in the organization are consistently in awe of


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someones technical or creative ability, this provides additional insight

into the persons capabilities.

If there are concerns about capability, respond

accordingly. If someones capabilities present a significant risk factor,

respond with stronger controls or enhanced audit testing. For example,

if the sales vice president is overly aggressive, competitive, and

obsessed with hitting monthly sales quotas, there may be a need for

extra-tight controls over revenue recognition or expanded testing of

sales during the annual audit. In addition, implementing a periodic

rotation of routine, but key, functions among staff can minimize the

opportunities for fraud gained from long-term knowledge of the

function and its controls. In this response phase, a key to mitigating

fraud is to focus particular attention on situations offering, in addition

to incentive and rationalization, the combination of opportunity and

capability. In other words, Do we have any doorways to fraud that canbe opened by people with the right set of keys? If so, these areas are

especially high risk, because all the elements are in place for a fraud

opportunity to become reality.

For example, when designing detection systems, it is important

to consider who within the organization has the capability to quash a

red flag, or to cause a potential inquiry by internal auditors to be

redirected. Cynthia Cooper, the internal auditor at WorldCom credited

with discovering the massive fraud, has described in Time magazine

how CFO Scott Sullivan had exercised his position and seniority to

dissuade her team from looking into certain areas that later proved to

have been infested with massive fraud. But believing they were on to

something, her teams worked behind Sullivans back, on many

occasions at night or from home, to avoid detection and retribution.

Although it appears he tried, according to Cooper, in this instance

Sullivan was not capable of completely thwarting the persistent efforts

of the auditors to uncover the apparent fraud.

Reassess the capabilities of top executives and key

personnel. Assessing capability and responding to concerns should

not be viewed as one-time exercises. Continuous updating of thecapability assessment and response is warranted for two reasons. First,

people can develop new capabilities over time, especially if they are

climbing the corporate ladder and growing professionally. Just because

someone did not have enough power or knowledge of an area to

commit fraud in the past, there is no guarantee that the person will not

develop such power or knowledge in the future. Their capability to


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commit fraud may increase, and additional controls or scrutiny may be

warranted.

Second, organizational processes, controls, and circumstances

change over time. As a result, some people may be better suited to

commit fraud in the new environment, even though they were not

capable under previous conditions. For example, consider a company

that has recently implemented a complex new IT system. The new

system may render those less digitally sophisticated employees

incapable of exploiting its controls. On the other hand, for those with

strong IT skills, the change might increase their capability of

committing fraud. This new capability should be considered, and

appropriate responses implemented.

Beyond Standards

In the final analysis, recent legislation, increased enforcement,regulatory oversight, broader controls, improved auditing standards,

and sophisticated monitoring technology are all steps in the right

direction and will contribute to preventing and detecting fraud.

Limiting this effort to current standards and practices may not be

enough, however, especially for auditors. Consistent with this view, the

2004 Miller GAAS Guide describes the fraud triangle elements

presented in SAS 99 and notes that it is obvious that the Auditing

Standards Board is struggling with the broad topic of how to detect

fraud auditors should be careful about following relevant

professional standards and then having a sense of security about the

likelihood that fraud does not exist in a particular engagement.

Accordingly, if capability could play a role in influencing or

magnifying the other fraud elements, other checks and balances or

detection systems should be implemented, or an auditor should

expand audit scope, procedures, and testing for potential fraud.

fraud red flags

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