Red flags of management fraud.
Fraud can broadly be defined as the act of knowingly making misrepresentations of fact with the intent of gaining unfair advantage over another person or organization. Elliot and Willingham (1980) state that the law distinguishes between actual fraud, which is intentional, and constructive fraud, which is not deliberate. Often, acts of fraud are referred to as white collar crime, in contrast with more violent crime. Cottrell and Albrecht (1994) point out that violent crimes have clear physical evidence of their existence, whereas fraud as a crime is often not directly observed. Neither do fraud perpetrators typically fit the profile of other criminals. Edmonds asserts that it is hard to distinguish occupational criminals from average citizens.There are several types of fraud: for example, fraud by employees, fraud by management and fraud by non-related outsiders. This article will concentrate on management fraud and the red flags that might indicate that it is occurring. Types of fraud can be grouped into two major categories defined by Albrecht and Romney (1986) and based on motivation. These motivational factors are: those that motivate some persons to commit fraud on behalf of a company and those that motivate persons to commit fraud against a company.
Cushing and Romney (1994) describe the three steps involved with fraud. The first step is the actual theft of an asset. The second is the transformation of the pilfered asset into a form that is more useable to the perpetrator, e.g., the stolen asset is converted to cash. The last step is the concealment of the theft by altering documents or records. These coverup activities provide an important trail to the fraud investigator to help unravel the fraud.
Fraud Prevalence
Fraud is becoming more prevalent throughout business in the United States. Over the last four decades there has been a marked increase in the number of frauds and their costs. Cottrell and Albrecht (1994) relate that in health care expenditures alone, it is believed that fraud accounted for nearly 10% of the $800 billion spent in 1992.
The increase in fraud cases has been attributed to an increase in the advantages received from committing fraudulent acts and a decrease in the risk of being caught and punished. The benefits of management fraud are escalating. Hundreds of millions of dollars have been involved in some individual cases. While the advantages rise, many companies fail to prosecute perpetrators of fraud, or the criminal justice system fails to convict or punish them severely. The increase in cases and the staggering amounts involved have prompted auditing firms, accounting regulatory bodies, government and investors to search for additional and improved methods of prevention and detection.
Fraud Detection Problems
The prevention and detection of fraud becomes increasingly critical as its frequency of occurrence and costs continue to grow. Controls to aid in the prevention of fraud are well known to auditors and accountants. As long as internal controls do not exist within an organization - or if such controls are disregarded - the problem changes from prevention to detection.
It would seem that fraud would be easy to detect because of auditor training methods, the lack of complex concealment in many instances and the increased number of cases. In fact, fraud detection continues to be difficult even in cases involving blatant material misstatement of accounting records. Detection becomes even more difficult when the perpetrators, offering large incentives, enlist supposedly independent auditors to become a part of the scheme. Most fraud cases are discovered by accident or through co-worker complaints. Wells (1990) states that only 20% of detection is made by auditors in the course of their duties.
Wells suggests that CPAs need to debunk certain myths about fraud to meet their expanded responsibilities to uncover and control it. The first myth is that most people will not commit fraud. Many people will commit fraud given motive, opportunity and a defective set of values. The second is that fraud is not material. Many frauds have caused the complete failure of businesses and have even had an effect on large segments of the population of the United States. The third is that fraud goes undetected. Eventually, most frauds are revealed, even though they may not be reported. The fourth is that fraud is usually well-concealed. Nearly half of frauds are detected by accident. Most are not well-concealed in the least. Auditors are often surprised at the lack of concealment. The fifth is that auditors cannot do a better job in fraud detection. The final myth is that prosecution of perpetrators deters others from committing fraud. It often does prevent the convicted offender from committing additional frauds but does not necessarily discourage others from performing criminal acts.
The following section will summarize previous "red flags" literature related to fraud detection. This will be followed by an application of 86 red flags, as compiled by Albrecht and Romney (1986), to the 30 cases of fraud discussed within the text Contemporary Auditing: Issues and Cases, 2nd ed., by Michael C Knapp. This application will be used to determine if some or any of the red flags applied might have value in the discovery of fraud.
Fraud Indicators
Possible indicators of management fraud have been compiled by several noted professionals. This section will summarize a number of these articles. Catlett (1974) has shown that of significant fraud cases, most are the result of a breakdown in internal control. This breakdown occurs as a result of management direction, collusion of officers and/or employees, neglect or a combination of these and similar factors. This breakdown in internal control should be viewed as both an indicator and opportunity for fraud.
In their study of the health care industry, Cottrell and Albrecht (1994) maintain that rather than for physical evidence, auditors may have to look for symptoms of fraud. To support the detection of fraudulent activities, they recommend that auditors, managers and department heads should learn to recognize these symptoms. If they exist, interested parties should fully investigate to insure that fraud is not present. The six categories they suggest as recognizable symptoms are:
1. accounting irregularities; 2. internal control weaknesses; 3. analytical anomalies; 4. lifestyle changes; 5. behavioral changes; and 6. tips or complaints.
Cottrell and Albrecht suggest that these symptoms are neither predictive nor absolute. There may be one or more symptoms present in a particular case of fraud, but having one or more symptoms does not mean that a fraud has definitely occurred. The person observing these symptoms must recognize the possibility of fraud and may wish to proceed to a full investigation.
Groveman (1995), in his article concerning detection of financial statement misstatement, wrote that "The most frequent causes of audit failure appear to be inappropriate audit team reactions to various warning signals." Auditors need to understand these warning signs and then properly act upon them.
Overstatement of inventories, overly aggressive accounting, inappropriate revenue recognition, inadequate loss reserves, understated costs and expenses and unusual or related party transactions were viewed as indicators of financial statement misstatement. When indicators appear during a client audit, the auditors should be skeptical and further investigate to ensure that fraud, if existing, will not cause material misstatement of financial records.
Friedman (1995) admonished the management, accounting and auditing professions to pay attention to warning signals that may indicate fraud. Some of the major signals are: an excessively complex organizational structure, unusually structured partnerships and joint ventures and replacement of the client's accounting firm. Friedman also advises that auditors need to be more skeptical of their clients and watch for fraud indicators.
Coopers and Lybrand (1977) listed many indicators that should raise suspicions. These indicators are listed in Table 1.
The Accounting Standards Board (ASB) of the AICPA has proposed a new Statement on Auditing Standards (SAS) concerning the consideration of fraud in a financial statement (AICPA 1996). Within the proposed SAS, fraud is categorized into two types: fraudulent financial reporting and misappropriation of assets. The fraudulent financial reporting type generally refers to management fraud; the misappropriation of assets refers to acts committed against the entity, most often by employees. The proposed SAS lists risk factors related to fraudulent financial reporting within three categories:
1. management characteristics; 2. industry conditions; and 3. operating characteristics and financial stability.
The proposed SAS gives many examples of each of these categories to aid auditors in determining how to evaluate risk factors indicating fraud, which might materially misstate financial statements. These examples are similar to the other indicators provided within article.
Robertson (1996) also lists several indicators of management fraud. These indicators are listed in Table 2 on page 32.
Romney, Albrecht and Cherrington (1980) present a fraud-risk evaluation questionnaire that might be useful to auditors in the course of client audits. Variables were prepared taking into account the situation, opportunity and personal characteristics. The variables were then validated against 72 past cases of fraud. The variables that could be associated with these cases were then used to construct the questionnaire. The authors point out that the questionnaire was difficult to answer and that it needed additional validation.
Albrecht and Romney (1986) continued this line of research by creating and using two questionnaires to validate the use of red flags as management fraud indicators. One questionnaire was used as a control group instrument and was sent to audit partners on engagements where fraud was not found. The second questionnaire was sent to auditors whose clients had experienced management fraud.
The questionnaires resulted in 86 red flags that were placed into one of three groups. These groups were: significant red flags, red flags that were not significant and untestable red flags. The untestable group was formed from returned questionnaires that were not of the proper number to make them statistically significant. The examination concluded that the significant red flags group had predictive ability and that auditors could use the study in determining which red flags to use in their audits. See Table 3 for a list of the 86 red flags.
Pincus (1989) completed a study of the use of red flag questionnaires to help auditors assess the risk of material fraud during an ordinary audit engagement. The subjects were mid-level accountants at a large CPA firm. Approximately half of the subjects used questionnaires; the other half did not. The results of the study indicated that the questionnaires led to increased comprehensiveness and uniformity in data acquisition, but did not show that usage of questionnaires aided in the assessment of fraud risk.
A Validation of the 86 Red Flags
In this study, the 86 red flags used and validated by Albrecht and Romney (1986) were subjectively applied to 30 known and relatively infamous cases of fraud. (See Table 4 for a list of the companies.) This list of red flags was used because of its broad coverage of various areas and to take advantage of previously completed research.
The fraud cases employed were those detailed in the text, Contemporary Auditing: Issues and Cases. Each of the red flags was rated by a point system as to whether or not it was present in the write-up of the fraud. The points for each red flag were then totaled to determine which were often indicators of fraud and which were not. The following point system was employed to rate the predictive ability of each of the 86 red flags in each of the 30 cases of fraud.
N: The red flag was not observable due to insufficient data in the case summary; it may or may not be applicable to the case.
0: The red flag was not observed to be an indicator in the case.
1: The red flag was somewhat observed to be an indicator in the case.
2: The red flag was definitely observed to be an indicator in the case.
Discussion
The analysis of red flags as explained in the previous section has revealed which ones are likely indicators of management fraud. The ten leading indicators, as sorted by total points assigned, are listed in Table 5 (see page 56). The four flags with highest point scores were also the prime indicators for a large majority of the fraud cases. Eight of the top 20 red flags were also within the top 16 indicators as calculated by Albrecht and Romney (1986).
It should be noted that red flags that did not receive many points may still be valid indicators of fraud. They may also be good indicators of non-management fraud.
There are several limitations that need to be considered when applying the red flag analysis to particular situations:
* The numerical ratings were subjectively assigned.
* The information in the write-up of the fraud cases may have been incomplete or incorrect.
* The cases selected may not be a sufficiently broad, representative sample.
* There was not a control group. Therefore, the predictability of red flags could not be proven statistically.
Even with these limitations, the use of red flags may be helpful during the course of an audit. The auditor must bear in mind that these are not absolute indicators and act accordingly.
Table 1: Coopers & Lybrand Fraud Indicators
1. Tight credit, high interest rates and reduced ability to acquire credit.
2. A profit squeeze as a result of sales and revenues not having kept pace with increasing costs and expenses.
3. The need for additional collateral to support existing obligations.
4. Difficulties in collection of accounts receivable from classes of customers who may be experiencing severe economic pressures.
5. Dependence for success on a single product or a small number of products, customers or transactions.
6. Competition from low-priced imports.
7. Existing loan agreements with little flexibility in their working-capital ratios; limits on additional debt and the terms of the payment schedule.
8. Existence of revocable (and possibly imperiled) licenses necessary for continuation of the business.
9. Management tendency to exert extreme pressure on executives to meet budgets.
10. Significant inventories and other assets that require special expertise for valuation.
11. A long manufacturing cycle, which may have an adverse impact when costs are rising and products have to be sold at fixed prices or in competitive markets.
12. Unusually rapid expansion of product lines.
13. Sizable inventory increases without comparable sales increases.
14. Suspension or de-listing from a stock exchange.
15. Unmarketable collateral.
16. Pressure to finance expansion via current earnings rather than through equity or debt.
17. A cash flow shortage, negative cash flow or lack of sufficient working capital and/or credit to continue the business.
18. Significant reduction in sales order backlog, heralding a future sales decline.
19. Massive demands for new capital in a developing industry and/or unusually heavy competition.
20. A declining industry or one characterized by a large number of business failures.
21. Excessive capacity due to economic or other conditions such as energy shortages.
22. Reluctance by management to provide additional information to improve the clarity and comprehensiveness of the company's financial statements.
23. Urgent desire to maintain a continued favorable earnings record in the hope of supporting the price of the company's stock.
24. Numerous acquisitions of speculative ventures in pursuit of diversification.
25. Existence of significant litigation, especially between shareholders and management.
26. Progressive deterioration in the "quality" of earnings, e.g., adoption of straight-line depreciation to replace sum-of-the-year-digit depreciation without good reason.
27. Significant danger of product obsolescence in a high-technology industry.
28. Significant tax adjustments by the IRS, especially when they occur with some regularity.
29. Executives with records of malfeasance.
Table 3. Albrecht and Romney's Red Flag Indicators
1. Key executives with high personal debts or financial losses.
2. Key executives with perceived inadequate incomes.
3. Key executives living beyond their means.
4. Key executives exhibiting strong greed.
5. Close association between key executives and suppliers.
6. Failure to require executives to take vacations of more than one or two days at a time.
7. Lack of explicit and uniform personnel policies.
8. Failure to record dishonest acts and other disciplinary action.
9. Dishonest or unethical management.
10. Failure to pay attention to details.
11. Too much trust in key executives (overlooking controls).
12. Inadequate internal controls or failure to enforce controls.
13. Reluctance to provide auditors with needed data.
14. Poor staffing of accounting department.
15. Key executives with low moral character.
16. Key executives who frequently rationalize failures.
17. Key executives who are "wheeler dealers."
18. Company trying to gloss over temporarily bad situation.
19. Continually operating on crisis basis.
20. Unduly complex business structure.
21. An urgent need to report favorable earnings.
22. Big inventory increases without comparable sales increase.
23. The existence of strong management incentives for high earnings (bonus dependence).
24. Domination of the company by one or two strong individuals.
25. Large number of year-end or unusual transactions.
26. Poor accounting records.
27. Failure to inform employees about rules of personal conduct.
28. Poor compensation practices.
29. Deteriorating quality of earnings.
30. Significant related party transactions.
31. Need for, but lack of, an internal auditing staff.
32. Key executives feeling undue family, peer or community pressure to succeed.
33. Business operations deteriorating significantly.
34. The company attempting to operate with insufficient capital.
35. Unusually high corporate debts and interest burdens.
36. Inability to realize return on assets.
37. High peer pressure (within the company) to succeed.
38. Company is in a high risk industry.
39. Having difficulty collecting receivables.
40. Pressure to sell or merge.
41. Adverse political, social, or environmental impact.
42. Retaining several different legal counsels, or changing legal counsels often.
43. Costs and expenses rising faster then revenues.
44. Severe losses from major investments.
45. Rapid expansion into new product lines.
46. Lack of key employee training programs.
47. Failure to require executive disclosures of investments, etc.
48. Liberal accounting practices.
49. An uncertainty of new products or services.
50. Little tolerance on debt restrictions.
51. Unfavorable economic conditions in the industry.
52. Inability to borrow; tight credit.
53. Heavy dependence on one or two products or customers.
54. Significant off-balance-sheet or contingent liabilities.
55. Use of several different banks, or frequent bank changes.
56. Special problems relating to accounting estimates or measurements.
57. Key executives with poor credit ratings.
58. Failure to adequately screen new key employees.
59. Key executives with questionable or criminal backgrounds.
60. Key executives involved in extramarital relationships.
61. Unrealistic productivity measurements.
62. Company retaining several different accounting firms or changing auditors often.
63. Poor system of physical security.
64. Key executives with strong desire to beat the system.
65. Key executives believe they are being treated unfairly.
66. Key executives who are unstable (frequent job changes, divorces, etc.).
67. Key executives frustrated with jobs.
68. Key executives involved in excessive gambling.
69. Key executives involved in extensive stock market speculation.
70. Poor interpersonal relationships among executives.
71. Unusually long business cycle.
72. Failure to disclose unusual accounting practices.
73. Key executives resent superiors.
74. Declining demand for products.
75. Company fears stiff competition.
76. Imperiled or revocable business license.
77. Severe obsolescence.
78. Recent severe tax adjustments.
79. Significant amount of unavailable collateral.
80. Significant litigation.
81. Excessive use of alcohol or drugs by key executives.
82. Suspension or de-listing from stock exchange.
83. Excess capacity.
84. Uncertain issues relating to public trading of stock.
85. Rapid turnover of key employees.
86. Continuous problems with regulatory agencies.
Table 4. List of Fraud Cases
Mattel, Inc. ESM Government Securities, Inc. United States Surgical Corporation ZZZZ Best Company, Inc. Lincoln Savings and Loan Association Crazy Eddie Inc. Penn Square Bank IFG Leasing The Fund of Funds, Ltd. Wedtech Corporation Doughtie's Foods, Inc. Flight Transportation Corporation The Trolley Dodgers J. B. Hanauer & Co. Giant Stores Corporation. Howard Street Jewelers, inc. E. F. Hutton J. B. Lippincott Company Porta-John Corporation Four Seasons Nursing Centers of America, Inc. Cardillo Travel Systems, Inc. Creve Couer Pizza, Inc. The PTL Club Phillips Petroleum Company Whittaker Corporation Fred Stern & Company, Inc. 1136 Tenants Corporation Yale Express System, Inc. First Securities Company of Chicago Equity Funding Corporation of America
Table 5. Top Ten Red Flags by Points 1. Dishonest or unethical management. 47 points 2. Too much trust in key executives (overlooking controls). 45 points 3. Domination of the company by one or two strong individuals. 42 points 4. Inadequate internal controls or failure to enforce controls. 39 points 5. Key executives with low moral character. 33 points 6. Key executives exhibiting strong greed. 24 points 7. Special problems relating to accounting estimates or measurements. 23 points 8. Reluctance to provide auditors with needed data. 21 points 9. An urgent need to report favorable earnings. 19 points 10. Liberal accounting practices. 18 points
Bibliography
Accounting Standards Board, American Institute of Certified Public Accountants. 1996. Proposed Statement on Auditing Standards: Consideration of Fraud in a Financial Statement Audit, AICPA.
Albrecht, W. S. & Romney, M. B. 1986. "Red-Flagging Management Fraud: A Validation." Advances in Accounting (3): 323-333.
Catlett, G. R. 1975. "Relationship of Auditing Standards to Detection of Fraud." CPA Journal (April): 13-21.
Coopers and Lybrand. 1977 "Red Flags for Fraud." CPA Journal (August): 76-77.
Cottrell, D. M. and Albrecht, W. S. 1994. "Recognizing the Symptoms of Employee Fraud." Health Care Financial Management (May): 19-25.
Cushing, B. E. and Romney, M. B. 1994. Accounting Information Systems, 6th ed. Reading, MA: Addison-Wesley Publishing Company.
Edmonds, C. D. "Value Focusing: A Personal Paradigm for the Deterrence of Unethical and Criminal Behavior in Business and the Professions." Business & Professional Ethics Journal (13:4): 65-80.
Elliot, R.K. And Willingham, J.J. 1980. Management Fraud: Detection and Deterrence. New York: Petrocelli Books.
Friedman, S. 1995. "Case Study: Pay Attention to Warning Signals." Journal of Accountancy (October): 65-80.
Groveman, H. 1995. "How Auditors can Detect Financial Statement Misstatement." Journal of Accountancy (October): 83-86.
Pincus, K. V. 1989. "The Efficacy of a Red Flags Questionnaire for Assessing the Possibility of Fraud." Accounting Organizations and Society (14:1/2): 153-163.
Robertson, J. C. 1996. Auditing, 8th ed. Chicago: Irwin.
Romney, M.B., Albrecht, W. S., and Cherrington, D. J. 1980. "Auditors and the Detection of Fraud." Journal of Accountancy (May): 63-69.
Wells, J. T. 1990. "Six Common Myths About Fraud." Journal of Accountancy (February): 82-88.
Dana Weisenborn, MS, is an office manager in the Ford Dodge location of the United States Gypsum Company. Daniel Norris, MS, PhD, is an associate professor of accounting at Iowa State University.
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| Author: | Weisenborn, Dana; Norris, Daniel M. |
|---|---|
| Publication: | The National Public Accountant |
| Date: | Mar 1, 1997 |
| Words: | 3715 |
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