Tracking fraud

For keen observers of financial statements, warning signs that indicate fraudulent business activities may be detected in overly optimistic statements and evasive attitudes of senior management.

How it works

Public companies are required to have their annual financial statements audited (checked) by an independent auditor. It is typically during this process that any financial shenanigans— creative accounting tricks used to manipulate the figures and improve the performance of a company in its financial statements—and outright fraudulent activity is uncovered. It is the auditor’s job to ensure that business records and statements are accurate and have been honestly reported. Auditors carry out a systematic examination of the company’s records and may identify any irregularities that may indicate fraud. If evidence of fraud is found, the next step is to involve forensic accountants and criminal investigators, who may prosecute the perpetrators.

Red flags indicating fraud

Auditors may be alerted to fraud by a number of recognized warning signs or
“red flags”; these may be either directly to do with the behavior of the CEO or other top executives, or in the form of irregularities within the financial statements.

Suspicious figures on financial statements

❯ Cash flows that are negative for three quarters, then suddenly and dramatically become positive

❯ Sudden increase in gross margin, at odds with industry average and company’s previous performance pattern

❯ Large sales to companies with dubious track records

❯ Sales recorded before they have been made

❯ Made-up, nonexistent sources of revenue

❯ Expenses moved from one company to another, or classified as assets

❯ Ongoing, long-term growth of earnings per share

❯ High payments to executives compared to base salary

CEO behavior

❯ Evasive behavior by executives over important financial details

❯ Attempts by CEO to steer auditors away from certain documents

Technicalities

❯ Late entry of sales or earnings adjustments

❯ Missing approvals or signatures

❯ Photocopied documents presented in place of originals

How to detect fraud

Procedures should be in place to hold accountable anyone who handles expenses. When these fall short, internal and external auditors need to take more drastic measures.

Applying ratio analysis to reveal key long-term trends

Setting up confidential hotline for current and
past employees or others with knowledge of the company

Using element of surprise, such as undertaking an aggressive internal audit without prior warning

Conducting a surprise cash count to determine whether current cash flow matches statements

Data mining with auditing software to detect any mismatch between past patterns and current statements

NEED TO KNOW

❯ Asset stripping Selling off the assets of a company for a profit to raise funds, often resulting in the closure of the business

❯ Tunneling A particular type of fraud in which assets and funds are illicitly transferred to management or shareholders