Fraud Detection: Red Flags

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This guide lists 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.

It provides a thorough list of indicators to watch for which may signal fraudulent
activity by individuals against the company.
The list of indicators is broken down into categories to help identify signs of personal
fraud, individual fraud on behalf of the company, and management fraud on behalf of
the company.
This guide also provides Fraud indicators for various business processes.

1. Opportunity Red Flags

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

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

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 iniquities 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
Urgent need for favorable earnings to support high price of stock or to meet earnings
forecast
Need to gloss over a temporarily bad situation in order to maintain management
position and prestige
Significant litigation, especially between stockholders and management
Unmarketable collateral
Significant reduction in sales backlogs (indicates future sales have declined)
Possibility of license being revoked or imperiled, especially if it is necessary for the
continuation of business
Suspension or desisting from a stock exchange
Pressure to merge
Sizable inventory increase without comparable sales increases
Consistently late reports
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 the 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.
May gamble or drink a great deal.
Buy expensive gifts for their families usually to compensate for spending so little time
with them.
Are hostile to people who oppose their views.
They feel exempt from accountability and controls because of their station or position.
Create a greet deal of turnover among their subordinates and often set off one
subordinate against the other.
Play favorites among subordinates, but the relationship can cool very quickly because
a subordinate often falls from grace after one mistake, even an insignificant one.
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 not enforced, 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)

Conflicting or Missing Evidential Matter

Missing documents
Unexplained items on reconciliations
Unavailability of other than photocopied documents
Inconsistent, vague or implausible responses arising from inquiries or analytical
procedures
Unusual discrepancies between the client's records and confirmation replies
Missing inventory or physical assets
Excessive voids or credits
Common names or addresses of payees or customers
Alterations on documents (e.g. back dating)
Duplications (e.g., duplicate payments)
Questionable handwriting on documents

Unusual Relationships With the Client

Denied access to records or facilities

Denied access to certain employees, customers, vendors, or others from whom audit
evidence might be sought
Undue time pressures imposed by management to resolve complex or contentious
issues
Unusual delays in providing requested information
Tips or complaints to us about fraud

Other Concerns

Significant internal control weaknesses or prior year internal control weaknesses not
corrected
Unusual transactions (e.g., for activities outside the normal line of business)
Changes in accounting principles or the methods of applying them that enhances
reported income
Departure of key financial or operating personnel
Specific instances of management's conduct that raise serious concerns as to their
integrity

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:
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.
Lack of segregation of duties between the following:
Processing of accounts payable invoice and updates to vendor master files
Check preparation and posting to vendor account
Check preparation and mailing of signed checks
No proper documentation of additions, changes, or deletions to vendor master file.
Excessive credit adjustments to a particular vendor and/or credit issued by
unauthorized department (credits involving quantities and price).
Systematic pattern of adjustments to accounts payable for goods returned.
No reconciliation performed of accounts payable subledger to general ledger control
account.

Insufficient supervisory review of accounts payable activity.

Lack of documentation for payment of invoices.
Cash disbursements for unrecorded liabilities and routine expenses (e.g., rent) when
all expenditures must be vouchered prior to payment.
Excessive mis-codings to same expense account.
Payments made on copies of invoices, not originals.
Paid invoices not properly canceled, allowing for reprocessing.
High volume of manually prepared disbursement checks.
Unrestricted access to blank checks, signature plates, and check-signing equipment.
Missing or easy access to blank checks, facsimile, and manual check preparation
machines.
Vendor invoices are received by department other than accounts payable
(purchasing).
Vendor complaints noted by credit rating services regarding slow or no payments not
justified by disbursement schedule.

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.

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.

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.

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.

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 non-responsible 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.
No segregation of duties between:
Receipt of inventory and issuing of materials
Recording of inventory accounts and ordering materials
Identification of obsolete and surplus materials and sale and disposal of such materials
There is no policy regarding inventory levels to be maintained (i.e., minimums,
maximums, reorder points).
Systematic pattern of improperly labeled inventory and raw materials.
Poor review of inventory accounts, write-offs, and physical access to storage areas.

Lack of regular physical inventories carried out by independent personnel.

Consistent production overruns beyond sales demand and backlog orders.
Excessive production waste, spoilage, or other loss of raw materials.
Physical replacement of finished goods within production area beyond a reasonable
period of time.
Abnormal expenditures for external maintenance services beyond normal repairs and
capability of internal repair service personnel.
Extended delay of goods marked for shipment maintained within shipping area.

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.
Increase in short-term cash and a decrease in receivables while sales are increasing
prior to seeking new financing.
A change in external activities, legal counsel, or treasury department head prior to
obtaining new financing.
A delay in issuance of monthly, quarterly, or annual financial reports prior to seeking
new financing.