What is a Red Flag in Financial Statement Fraud?

Financial statement fraud is a major problem for any business. Depending on the size of the company and the scope of the fraud that takes place, the very existence of the business could be in jeopardy. With that in mind, having systems in place to not only prevent fraud, but also to catch signs of fraud on the financial statements as early as possible is critical.

This article is going to look at some of the major red flags that might point to accounting fraud in your business. For a company to stay on track toward a solid, prosperous future, the financial statements need to be an accurate representation of what is going on inside the company. If that doesn’t happen, all bets are off and countless problems could result. Hopefully, this article will help you understand the basics of what to look for and why someone would manipulate financial statements in the first place.

If you suspect something inappropriate is going on with regard to accounting fraud in your organization, or if you would simply like to perform a review and put some solid controls in place, Space Coast Forensics is here to serve you. Take a moment to get in touch today and we’ll be happy to discuss our services and how we could get started.

What is Financial Statement Fraud?

Before we can go looking for any red flags that point to accounting fraud, we first need to be sure that we are on the same page with this topic. Financial reporting in the form of financial statements is an essential part of transparent operations for many businesses. It’s easy enough to take the numbers of those financial statements for granted as being true and accurate, but that’s not always going to be the case. Rather, it is possible for someone to commit accounting fraud in an effort to reap one type of benefit or another. Accounting fraud is not as uncommon as you might think, and it can be particularly damaging when it does take place.

For a definition, we can call financial statement fraud the intentional manipulation or misrepresentation of a company’s financial performance. Do honest mistakes happen on financial statements? Sure, it’s possible, as accounting can be messy and complicated, but that doesn’t constitute fraud. What we are talking about here is the purposeful misrepresentation of a company’s financial position with the goal of enjoying some type of gain. It’s possible for people both inside and outside of an organization to commit financial statement fraud in one way or another, although that person will need to have certain levels of access to execute it properly. Most of the time, accounting scandals come from inside, as those are the people with the most to gain.

Commonly, it is the desire to attract more interest from investors that leads people within an organization to commit fraud on the financial statements. For example, if the financial statements that a company publishes make it look like the operation is going strong and is turning a profit, investors may be more likely to get involved and put their money behind the business. In this way, a company’s financial statements have a lot to do with who wants to get involved as an investor and on what terms they are willing to dive in. When accounting fraud takes place, those investments may be made based on false information, and the money that is put into the business could be far more at risk than the investors were led to believe originally.

Financial fraud of this type could also be committed with the goal of personal gain. Perhaps it’s an executive that has bonuses that are tied to particular performance markers who wants to make things look as good as possible – even if those representations don’t really line up with reality. Accounting fraud cases can take on many different shapes with countless different motivations behind them. To combat accounting fraud, good internal controls need to be in place, to make sure the financial statements that are created can be believed by everyone who needs to see them.

Many Possible Red Flags

Given the many potential negative outcomes of accounting fraud, it’s important to watch for red flags that something dishonest may be going on behind the scenes. Ideally, the fraudulent activities would be caught before a financial statement is even published, so the damage of putting out inaccurate financial reporting is never incurred. Toward that end, let’s look at several different examples of red flags that might be cause for concern.

Unusual Financial Trends

Perhaps the best place to look for red flags in the financial statements is by picking out weird trends that don’t line up with how the business usually operates. As unpredictable as the business world can be, there are trends that can usually be followed – either up or down. Those trends can be internal, such as the seasonal fluctuations that a particular business may experience, or they can be external based on things like overall economic conditions in the market.

When numbers of the financial statements don’t match up with expectations based on trends, that doesn’t automatically mean that accounting fraud is taking place – but it does mean that a closer inspection is warranted. It’s important to take a closer look at surprising trends to see if they have a legitimate explanation or if they might be the result of fraudulent activities. If accounting fraud is taking place, catching it early by spotting odd trends could help to limit the damage.

Surprising Revenue Totals

The executives of an organization, along with any investors, should have a pretty good idea of how much revenue that organization is going to bring in over a set period. Of course, one can never perfectly predict revenues, but it should be pretty easy to target a range of numbers that would make sense for a quarter or year. When accounting fraud happens as a way to manipulate financial statements, it is sometimes the case that revenues appear far higher than what anyone expected, which is another red flag that needs closer inspection.

As an example, say a company forecast $1 million in revenue for the first quarter of a year. After that quarter ends, the financial statements are published and they show $1.5 million in revenue instead. That’s over the expected mark by 50% – and exceeding the mark by such a massive amount is certainly cause for greater inspection. If, on the other hand, the financial statement showed $1.1 million in revenue, it would be much easier to believe that the company over-performed by 10% (although it’s still important to be vigilant and confirm that the numbers are authentic).

Strange Expenses

Just as revenues can come in at an unexpected level, so too can expenses look out of place on a financial statement. Like everything else, expenses should follow a predictable pattern, and they should be very controlled. In fact, expenses should be more predictable than revenues, simply because expenses have to be approved by the company, whereas revenues represent the decision of another person or business to spend money. So, if anything, expenses should be easier to follow and anticipate, and anything that falls way outside of what was expected should be a reason to investigate.

This is where strong internal controls go such a long way to help prevent accounting fraud. When the internal controls are in place that make it difficult to add things to the expenses ledger without proper checks and balances, it will be difficult – and nearly impossible – for someone to manipulate the financial statements in this way. However, if those controls aren’t really in place or managed, and expenses are easy enough to put through with little oversight, there is no telling what could happen.

Complicated Transactions

The accounting profession is used to dealing with complicated transactions. If everything that happened in a business was just simple, direct transactions, there wouldn’t be much need for CPAs and other professionals in this space. Accountants are so important to the operations of businesses because they are able to properly deal with complicated transactions in a way that makes sense, represents the financial status of the company, and abides by the relevant laws.

With that said, some transactions that land on the books in the case of accounting fraud are intentionally convoluted with the goal of throwing the accountants off of the trail. If financial statement fraud is the goal, it’s possible that an individual or group of individuals will record particularly complex transactions to make it hard for the money trail to be followed. In fact, this could be a network of multiple transactions that all work together to accomplish their goals while simultaneously being too confusing for a single accountant to untangle.

Mismatched Data

A big part of what financial statements are supposed to accomplish is corroborating other documents or data within the business. In other words, accurate financial reporting is a great way to check on the business and make sure that everything is adding up as it should. When it does, that’s a nice confirmation that there is no meaningful level of fraud taking place. If things don’t align, however, accounting fraud may be going on and it will be time for a full-scale investigation. Inconsistencies across various forms of financial data should not be overlooked or ignored, but rather used as important signals that can help a business cut off any fraud activity soon after it starts.

Lacking Internal Controls

Sometimes, it’s not even necessary to have proof of accounting fraud to suspect that something is going on behind the scenes. If a business doesn’t have strong internal controls in place, that alone can be a red flag. In a large organization, if internal controls are lacking, it’s almost certain that someone is taking advantage of that oversight. That doesn’t mean you can start randomly accusing people of doctoring the financial records or anything like that, but it is a reason to dive deeper with the help of a forensic accountant to see what is going on and what damage it is causing.

Accounting fraud thrives when controls are lax. When businesses step up their internal controls and are determined to combat accounting fraud, perpetrating this type of crime gets far more difficult and it becomes less likely to succeed. Many of the most famous accounting scandals, and plenty that you haven’t heard of, got started because of controls that either were not in place or were not actively maintained.

Why Forensic Accountants Are Critical

As you can see from the discussion above, there are many possible red flags that might point to issues with financial reporting in a business. And, to be sure, some of these red flags can be monitored by people already within the organization in order to prevent fraud. For example, revenues that come in way outside of the expected range can be noticed by pretty much anyone, regardless of their history in the accounting industry. However, if a business is going to stay ahead of the curve on fraud problems and steer clear of the kinds of problems that lead to criminal prosecution, working with forensic accountants on an ongoing basis is a great step.

There are many ways that forensic accounting services can help improve the financial reporting process within a business. First, if there is already fraudulent activity suspected, the forensic accountants can investigate those issues carefully and put together proof that points the finger at the guilty party or parties. With prompt investigation, the financial position of the company can be protected and the validity of its financial reporting can be restored.

Perhaps even more importantly, forensic accounting services can help to create and implement good internal controls that will make it harder for anyone to perpetrate financial reporting fraud successfully. All of the various inputs and processes that lead to financial reporting should be carefully designed and monitored to make sure nothing suspicious takes place. There should be plenty of checks and balances along the way, and no one individual should have too much power or too much responsibility.

If it makes sense for the size of the business, maintaining an ongoing relationship with a forensic accountant to monitor the financial reporting process for signs of fraud is a great investment. Such a relationship will not only make the financial reporting system more reliable and less prone to fraud, but it will also give potential future investors more confidence. Knowing that the financial reporting offered by the company can be trusted, investors may feel more comfortable about how their money is going to be used.

Get Help Today

Spotting signs of financial statement fraud is important for many reasons, but it can be difficult to do without the help of a trained professional. Such professional assistance is available through Space Coast Forensics, so be sure to reach out today to get started. We will be happy to explain the services that we offer and provide you with guidance on what help is appropriate in your situation. Don’t wait any longer to act on this important matter.

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