Red Flags of Fraud

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After reading this chapter, you will be able to:

  • Recognize structural and operational defects that make companies susceptible to internal fraud.
  • Learn personnel practices that may increase the likelihood of fraud committed by employees.
  • Identify some of the most common red flags of fraud as they relate to a company‚Äôs accounting system and financial performance.

Structural red flags of fraud relate to the way that a company is set up and the policies and procedures that are in place. Those very systems create opportunities for fraud each day. Employees become familiar with operations, and they begin to understand what accounts are unmonitored, which areas of the company are poorly supervised, and what size of transaction that creates added scrutiny.

Creating a structure that discourages and eliminates fraud includes:

  • Crafting policies and procedures that prevent fraud, and monitoring them to ensure compliance
  • Management leading by example, with ethical behavior exhibited at all times
  • Monitoring of personal relationships that might lead to collusion in a fraud scheme
  • Educating employees about fraud and how to detect and prevent it
  • Having effective physical security in place to protect assets and data

Personnel red flags of fraud refer to the employment policies and procedures within a company, including hiring procedures, advancement policies, employee monitoring programs, and disciplinary standards.

A company that is actively preventing fraud in this area:

  • Uses employment screening tools prior to hiring new employees
  • Gives employees clear ethical policies by which they are expected to abide
  • Properly trains employees so that they are competent in their job functions
  • Maintains accurate and up-to-date personnel records
  • Treats employees fairly and equitably

Operational red flags of fraud highlight how a company does business each day. Do things run smoothly, minimizing the chance for errors and problems? Or are things managed in such a fashion that errors go unchecked and employees do whatever they want, whenever they want?

Key concerns for management should include:

  • Whether the company is often operating in “fire drill” or “crisis” mode?
  • Are there clear lines of authority?
  • Is segregation of duties in place so that no employee has too much control over one area?
  • Are authorization controls in place and monitored for compliance?

Accounting system red flags of fraud refer to the organization of the system and the level of internal controls that are in place. A good, secure accounting system cannot exist without internal controls, and the company cannot be free from error and fraud without such controls.

Some of the basic red flags that might be noted in a company’s accounting records include:

  • Unusual timing of the transaction. This includes the time of day, the day of the week, or the season.
  • Frequency of transactions. Transactions that are occurring too frequently or not frequently enough are suspicious. Each company has its own operating patterns, and the transactions should be booked accordingly.
  • Unusual amounts recorded. Take notice of whether an account has many large, round numbers entered. Consider whether some of the transactions in the account are far too large or far too small.
  • Questionable parties involved. Should the company be paying an outside party? Is a payment being made to a related party? Is the company paying large sums to a vendor whose name is not easily recognizable?

Financial performance red flags of fraud include aggressive goals and performance measures, both at the individual and company-wide levels. When a certain level of performance is mandated, by the boss, Wall Street, the bank, or otherwise, there can be a temptation to turn to fraud to meet these goals.

Companies whose financial performance suggests the possibility of fraud might include some of these signs:

  • Significantly outpacing competitors in the industry
  • Outstanding results when the rest of the industry has suffered a downturn
  • Unusual financial ratios when compared to competitors
  • Persistent cash flow problems, even when the company has regularly reported profits
  • A pattern of similar audit adjustments proposed year after year

Professional service red flags are present when a company has apparent trouble keeping an auditing firm or retaining attorneys, switches banks frequently, or otherwise has persistent difficult relationships with professional service providers.