Financial statement fraud

FINANCIAL STATEMENT FRAUD

Introduction

In the United States, the National Commission on Fraudulent Financial Reporting (the Treadway Commission) was appointed to identify casual factors that led to fraudulent financial reporting and on the steps to reduce such incidents. In 1987, the Treadway Commission suggested that the damage resulting from fraudulent financial reporting was widespread with a devastating ripple effect. Sufferers ranged from the immediate (shareholders and creditors) to the more remote (investor confidence in stock markets and the credibility of the audit profession).

A major obstacle to addressing the problem of financial statement fraud promptly is related to the difficulty of identifying the fraud soon after its occurrence. Because it is often a management fraud, it is well hidden from auditors, investors and other stakeholders and it is usually only discovered by chance or once the company is in financial difficulty, which may result in a takeover or insolvency. It is therefore important to attempt to manage the risk of fraud by using early warning signals such as “red flags”.

Red flags

Red flags are events, conditions, situational pressures, opportunities or personal characteristics that may cause management to commit fraud on behalf of the company or for personal gain. They can be used as an early warning system by both auditors and other stakeholders to assess the risk of financial statement fraud. Although red flags may not necessary indicate the presence of fraud, they are conditions believed to be commonly present in the event of fraudulent activities and may therefore warrant concern.

In the past red flags were addressed from the perspective of the auditors. The problem is that the red flags identified by auditors are not necessarily relevant to lenders and investors. Lenders and investors require red flags that are appropriate to their particular interests and their access to information on the company and its management. It is also lenders and investors who may take legal action against auditors and management based on their perception of negligence in respect of financial statement fraud.

The survey

A questionnaire was developed to survey the opinions of lenders and investors in South Africa regarding red flags. It was sent to a selected sample of lenders and investors. The survey addressed the use of red flags by lenders and investors, their opinion on the relative importance of individual red flags as well as the identification of additional red flags.

The questionnaire was derived from the red flags identified in the research of Albrecht and Romney (1986), and from the South African auditing standards SAAS 240 (SAICA 1997) and ED 137 (SAICA 2000). These red flags were, however, developed for use by auditors. Consequently, the researchers screened the red flags and eliminated those where the information would normally only be available to auditors. Also, duplicated red flags were omitted. No new or additional red flags were added to the questionnaire, but the surveyed target group was asked to identify additional red flags.

The nature of red flags in the questionnaire tended to be subjective and therefore the purpose of the survey was to obtain the opinions of lenders and investors concerning the relative importance of these red flags to them. In total 65 red flags were identified in the questionnaire. A scale was used to measure the perceived importance of these red flags ranging from negligible (1) to important (5). The questionnaire also asked participants in the survey to indicate whether they were familiar with the concept of red flags, had previously used red flags in decision making, had used formalised checklists on red flags and whether they believed such checklists were useful.

Results

Of the responses received to the survey, 61% were familiar with the concept of red flags, while 39% were not. Of the respondents that were familiar with the concept of red flags, 79% had previously used red flags in decision making, while 21% had not.

With regards to the respondents that had used red flags in decision-making, only 32% had used formalised questionnaires and checklists. It would therefore appear that the use of formalised questionnaires and checklists in South Africa is fairly limited.

In response to the question whether the use of questionnaires and checklists were useful in assessing risk of fraud in financial statements, 78% of the respondents agreed. The same respondents also indicated that such questionnaires and checklists were helpful in collecting relevant information.

Both lenders and investors identified the red flag “dishonest or unethical management” as the most important. However, they did not rank the same red flags as least important, although there were commonalities with respect to the three least important red flags. What was interesting about the three least important red flags was that they were all related to the operating characteristics of the company.

The most important red flags focused on management characteristics and influence over the control environment. This supports prior research that the best predictive red flags were those on the attitudes and situational pressures on management. A statistical analysis of the results (Mann – Whitney test) indicated however, that respondents did not necessarily attach more importance to this latter category.

The ten most important red flags identified

Rank	Lenders	Investors
1.	Dishonest or unethical management.	Dishonest or unethical management.
2.	There are frequent changes of legal counsel, auditors or external board members.	There has been a breakdown in accounting and control systems as reflected by the late issuing of financial statements or a qualified report.
3.	Management is dominated by one person (or a small group) and there is no effective oversight board or committee.	Suspension or de-listing from stock exchange.
4.	Suspension or de-listing from stock exchange.	Management’s reputation in the business community is poor.
5.	Inability to generate cash flows from operations while reporting earnings and earnings growth.	Management is dominated by one person (or a small group) and there is no effective oversight board or committee.
6.	Continuous problems with regulatory agencies.	There are frequent changes of legal counsel, auditors or external board members.
7.	There is a high turnover rate of key top management specifically financial executives.	Internal or external factors exist that raise substantial doubt about the entity’s ability to continue as a going concern.
8.	Internal or external factors exist that raise substantial doubt about the entity’s ability to continue as a going concern.	Continuous problems with regulatory agencies.
9.	Management’s reputation in the business community is poor.	Identification of important matters not previously disclosed by management.
10.	Reluctance to provide investors/bankers with needed data.	Inability to generate cash flows from operations while reporting earnings and earnings growth.

The ten least important red flags identified

Rank	Lenders	Investors
1.	Pressure is exerted on accounting personnel to complete financial statements in an unusually short time period as reflected by approval date of financial statements.	Rapid expansion into new product lines.
2.	Unusually long business cycles.	Pressure is exerted on accounting personnel to complete financial statements in an unusually short time period as reflected by approval date of financial statements.
3.	Rapid expansion into new product lines.	Unusually long business cycles.
4.	Limited collateral available.	Key executives feeling undue family, peer, or community pressure to succeed.
5.	The entity has a significant investment in an industry or product line noted for rapid change.	Key executives with perceived inadequate incomes relative to industry.
6.	Poor interpersonal relationships among executives.	Adverse political, social, or environmental impact.
7.	The entity is heavily dependent on one or a few products, customers or suppliers.	Insufficient internal audit personnel.
8.	Declining demand for products.	The entity has a significant investment in an industry or product line noted for rapid change.
9.	Key executives feeling undue family, peer, or community pressure to succeed.	Limited collateral available.
10.	Adverse political, social, or environmental impact.	Failure to inform investors about code of conduct and god corporate governance.

Respondents were also asked to identify any additional red flags not specifically covered by the questionnaire. The following were suggested:

· Merger and de-merger of group companies;

· Significant presence of financial executives at top management;

· A change in financial year-ends (making accounting results incomparable);

· Size of the auditing firm in relation to the client;

· Limited management oversight on remote operations;

· Unskilled, inexperienced executives pushed into positions prematurely;

· Frequent corporate restructuring;

· Significant changes in the structure of the income, fees and interest;

· Good news too good to be true;

· Wide fluctuations in financial ratios from year to year; and

· Share options being re-priced.

Summary

The aim of the survey was to consider the importance of red flags to lenders and investors in South Africa. An approach to red flags from the perspective of lenders and investors is a relatively under-researched area if compared to what was done from an auditor’s perspective.

It is however, important that auditors and managers take cognisance of the opinion of lenders and investors concerning red flags as reflected in this research. Negative perceptions of lenders and investors resulting from red flags can be reflected in a weaker share price, difficulties in obtaining funding and in the off-loading of shares.

References:

Albrecht, W.S. and Romney, M.B. 1986. Red-flagging management fraud: A validation, Advances in Accounting, vol. 3.

Elliot, R. and Willingham, J.J. 1980. Management fraud: Detection and deterrence, Petrocelli Books, Princeton, New Jersey.

Koornhof, C. and Du Plessis, D. 2000. Red flagging as indicator of financial statement fraud: The Perspectives of Investors and Lenders, Meditari.

Kneer, D.C., Reckers, P.M.J. and Jennings, M.M. 1996. An empirical examination of the influence of the “new” US audit report and fraud red flags on perceptions of auditor culpability, Managerial Auditing Journal, vol. 11, no. 6.

National Commission on Fraudulent Financial Reporting. 1978. Report of Treadway Commission, Washington.

Romney, M.B., Albrecht, W.S. and Cherrington, D.J. 1980. Red-flagging the white collarcriminal, Management Accounting, May.

South African Institute of Chartered Accountants. 1997. Fraud and Error, South African Auditing Standards no. 240, April, Kengray, Johannesburg.

South African Institute of Chartered Accountants. 2000. Auditor responsibility to consider fraud and error, the audit of financial statements, May, Exposure Draft 137, Kengray, Johannesburg.

Background and Author:

The article was written with the aim of highlighting a recent survey conducted amongst lenders and investors in South Africa, and obtaining their opinion regarding the importance of red flags to lenders and investors in South Africa.

The approach to red flags from the perspective of lenders and investors is a relatively under-researched area.

David Corbin is an experienced Internal Auditor with financial, operational, and strategic management exposure, with a strong background in audit tool applications, audit processes and forensic accounting and auditing.

David has 12 years internal audit experience at group level. His experience includes classroom and fieldwork instructions, guidance, mentoring, coaching, and audit project development (which includes budgeting, resource management and audit review).

He has successfully held positions ranging from Internal Auditor to Internal Audit Manager.

His qualifications include: CIA (Certified Internal Auditor); CCSA (Certified Control Self-assessor); and CFE (Certified Fraud Examiner).

He currently serves on the Technical Committee of IIA South African chapter, and a Quality Assurance Reviewer for the IIA South African chapter.

David Corbin CIA, CCSA, CFE.

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