Financial Statement Fraud: Detecting the Red Flags
Important: The red flags of financial statement fraud are distinctly different from those of asset misappropriation. Common general red flags of financial statement fraud:
• Accounting anomalies.
• Unusually rapid revenue and/or profit growth.
• Readily noticeable internal control weaknesses.
• Noticeably “aggressive” financial actions by senior management.
• Personality or character flaws of the CEO and/or other “C-level” executives.
Important: Of these general indicators, top management personality and character are by far the most compelling 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. However, most executives with ethical weaknesses also exhibit very noticeable signs of aggressiveness in almost everything they do—including making critical financial decisions. Examples:
• Overly domineering, disrespectful or abusive management style vis-à-vis subordinates.
• Actively “steering” internal and external auditors away from financial reports that could reveal the fraud.
• Secretive or distinctly evasive attitude regarding critical financial information.
Detection methods for general financial statement frauds:
• 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—focusing in particular on long-term trends and on comparisons between business units.
• Surprise audits and/or cash counts.
• Implementation of an anonymous, user-friendly tip hotline for use by employees, vendors and customers.
• Data mining using one of the common auditing software applications such as ACL or IDEA.
SPECIFIC RED FLAGS
As with asset misappropriation, there are also specific red flags of financial statement fraud that are present in many of the common varieties of such accounting violations. Examples:
• Complex or unstable organizational structure.
• Unusually intricate or confusing financial transactions with third-party entities.
• Sudden or gradual increase in gross margin compared with the company’s prior performance, and with industry averages.
• Cash flows that are negative for the first three quarters and suddenly positive for the fourth quarter—not by just a little, but by more than all losses to date. (This scenario is exactly what happened at Enron. It is why Sherron Watkins said, after the company’s demise, that if anyone had been paying attention to the cash flows they would have known that Enron’s statements were suspicious and/or fraudulent.)
• Significant sales to companies or individuals whose identity and business track record are questionable.
• Sudden above-average profits for specific quarters.
• Executives or board members have direct personal dependence on the company’s performance.
• Conspicuously lax board oversight of top management.
Also similar to asset misappropriation, financial statement fraud has distinct categories. Each has its unique red flags and detection methods. Examples…
• Revenue recognition or timing schemes—also known as improper treatment of sales. This fraud category is possibly the most common form of financial statement fraud—usually employed when management seeks to conceal the real numbers for a weak quarter or two. Red flags:
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. One of the oldest financial statement schemes around— this involves posting sales that simply never occurred. Red flags:
— 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.
— 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). By shifting expenses from one entity to another or reclassifying liabilities as assets, which is what got WorldCom into trouble when it improperly reported $3.8 billion in expenses as capital expenditures, management can make the company’s financial condition appear much rosier than it is. Red flags:
— 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.
— Writing off loans to executives or other parties.
— Failure to record warranty-related liabilities.
• Inadequate disclosures. This tactic is used after a financial statement fraud has occurred—in an attempt to cover it up. Red flags:
— Disclosure notes are so complex that it is impossible to determine the actual nature of the event or transaction.
— Discovery of undisclosed legal contingencies.
• Improper asset valuation. Fraudulently inflating asset valuations is a common form of profit manipulation. Red flags:
— Unusual or unexplained increases in the book value of assets such as inventory, receivables, longterm assets, etc.
— Odd patterns in relationships of assets to other components of the financial report, such as sudden changes in the ratio of receivables to revenues.
— GAAP violations in recording expenses as assets.
To reduce the risk of having these frauds occur—or continue undetected— auditors should use such practices as…
• Horizontally and vertically analyzing all financial reports.
• Conducting frequent ratio analysis, including assessment of trends over periods of several years.
• Using Beneisch’s Ratios which pinpoint anomalies in year-to-year measures of gross margins, sales growth, receivables levels and other key accounting ratios.
• Rigorously applying the guidance of SAS 99 to all audit exercises.