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

 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

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

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 patterns 2) 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/or profits, 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.

 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 to get 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

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 for routine 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.

 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:

 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) 7) 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 of material, inventory, or fixed assets. Unrestricted access to inventory storage areas by nonresponsible 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. 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.

 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 than doubled 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 enforcement actions. 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 opportunity for the person to commit fraud, and the person can rationalize the fraudulent behavior (attitude). This three-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

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 fraud opportunity 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

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 to influence 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 publiccompany 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 the perpetrators 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

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, selfabsorbed, 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 Finding Auditors 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

fraud on a daily basis. Former HealthSouth CEO Richard Scrushy now faces numerous criminal charges for allegedly masterminding a longrunning 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 address capability 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 or the 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

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 can be 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 the capability 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

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.