Last updated: 26 Jun 2023 02:00 Posted in: Anti-money laundering
Oriol Amat and Pilar Lloret identify the warning signs to identify whether fraud has occurred or is likely to occur in a business.
Accounting fraud causes serious damage. In many cases, it ultimately brings down the company concerned and causes significant losses to those who have placed their trust in it, be they shareholders, employees, banks, suppliers or other interested parties. It is therefore a good idea to detect fraud before it is too late.
The Global Economic Crime and Fraud Survey 2022 from PWC reports that nearly half of the organisations (46%) reported experiencing some form of fraud within the last 24 months.
According to the latest report by the Association of Certified Fraud Examiners (ACFE), Occupational Fraud 2022, accounting fraud is the type of business fraud that causes the highest losses to companies. The same report indicates that 42% of frauds are discovered as a result of tips, usually from employees, or by chance (5% of cases). Internal auditors discover 16% and external auditing 4% of cases.
On the other hand, in many of the most relevant accounting and financial scandals, it can be seen that the existing signals were ignored. This is what happened with the Madoff case in 2008 or the Wirecard scandal in 2020. These are cases in which there were many reports that something serious was going on.
These data suggest that it is advisable to carefully examine the warnings signs or red signals that inform about a high probability that a company is a strong candidate for accounting fraud in the future or that it is very likely that an accounting fraud has already occurred.
This article includes some of the main red signals that can be perceived by examining the qualitative information of a company and its annual accounts. They include a selection of different red flags proposed in Lloret, Arimany and Amat (2023).
Types of red flags
The signals proposed will be made taking into account two types of classifications:
1: When the red signals can be detected:
● Before the fraud is committed:
These are aspects that increase the probability of having a fraud in the future. This may be the case, for example, of a company that has a very aggressive bonus system for its managers, which can lead to the manipulation of accounts. Another example is when a company has very poor control systems, which is a good opportunity to commit fraud. In these cases, there is a greater likelihood of accounting fraud.
● After the fraud has occurred:
Once the fraud has been committed, there are also signs that can be observed. An example would be when there are very important and unjustified changes in some accounts; such as, for example, depreciation of fixed assets. It is important to check these types of signals because they can influence decisions about this company; for example, giving or not a bank loan, or investing or not in the shares of the company.
2: The type of the red signal:
● Qualitative signals:
These are signals related to aspects like the characteristics of the people or the organisation; for example, a change in a manager’s habits that can be perceived when they start incurring very luxurious expenses.
● Signals in the accounts:
The accounts provide very interesting red signals; for example, when the level of indebtedness in a balance sheet is very high, it is more likely that the company can have accounting frauds in the future.
55 red flags
Qualitative signs that warn before a fraud is committed:
These are signals that warn before an accounting fraud is committed; for example, when a company has subsidiaries in tax havens where there is no obligation to disclose accounting information. Other types of signals are related to special moments, such as an initial public offering (IPO). The profiles of individuals, corporate governance problems, deficient control systems or incentive systems also provide interesting red signals. Various signals of this type are shown below:
Company profile
1. Complex corporate structure
2. Subsidiaries in tax havens where there is no requirement to disclose accounting information
3. Legal sanctions in the past
Moments with more motivation for fraud
4. Initial public offering in the stock exchange
5. Takeover bid
6. Changes in the top management of the company
7. The company requires more financing
People in the organisation
8. Legal sanctions in the past
9. Bad financial habits (a lot of debts or very luxurious lifestyle)
10. Low ethical standards
11. Managers or employees who do not take all vacations
12. High proportion of managers
Corporate governance
13. Conflicts in the board of directors
14. Deficiencies in corporate governance
15. Lack of independent directors
16. Lack of fraud prevention regulations (e.g. a code of ethics)
17. Lack of a channel for whistleblowers (anonymous tips)
Control systems
18. No audit committee
19. Inadequate auditors
20. Audit cost that is very low in comparison with comparable companies
21. Change of the auditing firm before the end of the contract
22. Conflicts with auditors
Financial practices
23. Unusual or complex operations that are difficult to understand
24. Difficulties in meeting covenant targets that may result in early loan termination.
25. Frequent claims to insurance companies
Bonus system
26. High aggressive bonuses for short-term result
Qualitative red signals that warn about a high probability that an accounting fraud has been committed:
There are other types of signals that are indicative that an accounting fraud has most likely already occurred in the company. These are signals related to the characteristics of the company, people, control systems or reports from analysts and rating agencies. See below:
Characteristics of the company
27. It has been delisted
28. Sanctioned by the authorities
Owners, officers or employees
29. Changes in lifestyle habits
30. Selling shares without logical explanation
Control systems
31. Qualified audit reports
Reports from analysts and credit rating agencies
32. Negative or worsening reports
Media and communications
33. Negative news alerting of irregularities or conflicts
Red signals in the accounts that warn before an accounting fraud is committed:
Financial accounts (such as the balance sheet, income statement, cash flow statement) also provide signals that may suggest that the company is a strong candidate for accounting fraud. This includes companies that have a lot of debt, little liquidity or negative results.
For example, a company with a ratio of debt against assets of 95% could offer a red signal because the excess of debt is one of the most common characteristics of companies which have accounting frauds. See signals below:
Balance sheet
34. Low current ratio
35. High debt
Income statement
36. Insufficient revenues
37. Negative or insufficient earnings
38. Lack of cash flow
Red signals in the accounts that warn about a high probability that an accounting fraud has been committed:
Financial accounts can also offer clear signals that a fraud has been committed. In this case, attention must be paid to significant and unjustified variations in the accounts. We are referring to variations in the balance sheet or in the income statement that are greater than the variation in sales, for example; or much greater than what is happening in comparable companies in the industry. See signals below:
Accounting policies
39. Change in accounting criteria
Balance sheet
40. Unusual increase or decrease in the capitalisation of expenses, intangible assets, deferred tax assets, provisions or similar accounts
41. Very surprising positive data considering the history of the company and the situation of the industry
42. Liquidity problems
43. High variation in ratios like asset turnover, customer days or inventory days
44. Too much debt
Income statement
45. Not very credible estimates
46. Inconsistency between sales and the evolution of operating data like number of stores or number of employees
47. Unusual changes in the income statement
48. Important changes in depreciation, amortisation or impairment or very different from those of the industry
49. Very surprising positive or negative data considering the situation of the industry
50. Higher portion of revenues based on estimates
51. Insufficient or negative earnings
52. Significant earnings in operations near year-end
Cash flow statement
53. Relevant discrepancies between profit and cash generated by operations
54. Profit grows but cash generated declines
55. Insufficient or negative cash flow
When we detect that a company presents a lot of red signals, it can be interpreted as this company having a higher probability to have a fraud in the future or to have committed a fraud in the past. This means that increased caution is required.
Conclusion
In this article, we have listed a total of 55 red signals that can help us to identify companies that have either a high probability of accounting fraud in the future, or that the fraud has already occurred. These signs can be of great help in detecting these situations before it is too late. To avoid problems, it is important to pay attention to the red signals.
Keep in mind that the existence of red flags does not necessarily mean that an accounting fraud has occurred. However, the more red flags there are, the greater the likelihood that accounting fraud has occurred (or will occur in the future).
1. Lloret, P, Arimany, N and Amat, O (2023): ‘Comprehensive red flag model for accounting fraud detection using qualitative and quantitative variables’, in Research Handbook on Financial Accounting, Edward Elgar Publishing (forthcoming).
Author Biography
Oriol Amat is the Professor of Accounting at Pompeu Fabra University.
Pilar Lloret is a Consultant at UOC and PhD candidate at UVIC-UCC.
"When we detect that a company presents a lot of red signals, it can be interpreted as this company having a higher probability to have a fraud in the future or to have committed a fraud in the past. This means that increased caution is required."