Six Red Flags of Financial Statement Fraud

Sep 26 '22 November 26, 2022

Many incidents of fraud are discovered inadvertently. For example, a staff member may notice something that doesn’t seem right and mentions it to a manager. Upon investigation, internal theft is found. But considering the potential damage that fraud can inflict on a company, it is obviously better to do more than depend on mere chance.

A Highly Orchestrated Fraud

    Early detection is critical to minimizing losses, as one large retailer found after an elaborate fraudulent scheme was discovered.
    Facts of the case: A vendor sued a division of the retailer charging that the company had been taking excessive discounts.
   A manager for the retailer reviewed the transactions and quickly determined the excessive discounts were triggered by an “accounting error.” In order to settle the matter and avoid adverse publicity, the manager authorized paying the amounts the vendor was claiming.
    Unfortunately, that was a bad move for the retailer. It turned out the excessive discounts weren’t the result of an accounting error. A highly orchestrated fraud had been in place for about years. Multiple management levels were aware of — and even encouraged — the fraudulent discounting practice. In some cases, managers received performance bonuses and promotions.
    Ultimately, the retailer had to restate three years of earnings and attempt to settle additional vendor lawsuits triggered by the publicity.
    The company fired the manager for his role. He should have recognized that accounting errors are one of the red flags of fraud. The full scope of the scheme wasn’t uncovered until three years after the initial lawsuit was settled.
    After a forensic accountant was engaged, the document trail detailing the fraud was found to be staggering. The perpetrators sent numerous e-mails discussing fake invoices. In addition, bogus documents were organized in thousands of binders and about 30 lower level staff members received training in how to prepare fake invoices.
    The company could have limited the financial impact and negative publicity if it thoroughly investigated the circumstances surrounding the first lawsuit.

Keep in mind that the earlier a company detects fraudulent activity, the less damage will be done. With that in mind, here are six red flags that can suggest wrongdoing in your workplace:

1. Unfair practice charges. If your company is sued and the lawsuit involves allegations of unfair business practices, treat the charges as an indication that there may be fraudulent activity.

2. Sudden lifestyle changes. If a staff member buys a larger home, enrolls children in private schools, or starts taking numerous overseas vacations, consider further investigation.

3. Management behavior. Manager’s actions should be monitored closely to determine if they are acting ethically. Do they have a reputation for succeeding at all costs? If management fails to lead by example, lower level employees may decide that they can also pursue unethical behavior.

4. SOX Section 404 non-compliance. If your company is public and has been notified that it isn’t complying with Section 404 of the Sarbanes-Oxley Act, start looking into weaknesses in your company’s internal controls — with fraud in mind.

Section 404 requires a company to include in its annual report a management report on the company’s internal controls over financial reporting. Notification of non-compliance not only means your controls need strengthening, it can be a sign that fraud is being committed.

5. Outperforming peers. Start asking probing questions if your company’s performance far surpasses that of others in the industry — particularly if your company’s sector recently experienced a difficult operating environment.

6. Past performance. You’ve likely seen the investing disclaimer that “past performance may not be indicative of future performance.” Within the world of fraud detection, past performance can actually serve as an indicator of future criminal activity.

An ethical climate doesn’t materialize overnight at a company. Depending on the size of previous frauds and whether or not all of the perpetrators were discovered and fired, your business could still be susceptible to new fraudulent acts.

Fraud detection and prevention is a highly specialized area of accounting. However, with the assistance of an attorney, certain clues can help a company proactively investigate fraudulent activity before it becomes a media event.