Red Flags Of Fraud Essay

A fraud is an act of deceiving others for personal gain but is not usually followed by a crime. The symptoms of fraud or the red flags help understand the slight difference between a corporate fraud and a corporate crime. The continual financial frauds leading to corporate collapse and the failure of the statutory audit to detect and prevent fraudulent activities of the perpetrators lead investors and the firms and individuals to suffer. This contributed to the increased need for investigating the on the red flags of fraud.

The purpose of this paper is to research on the elements of the fraud triangle which is opportunity, pressure and rationalization and identify the fraud symptoms and possible fraud perpetrators. The symptoms of fraud are a mechanism of detecting the fraudulent activities which would otherwise not be possible. Key words: fraud, crime, red flags, financial frauds, corporate collapse, perpetrators, fraud triangle, opportunity, pressure and rationalization The increase in the number of financial frauds reported and followed by corporate collapses has led to concerns about validity of corporate financial reports.

These concerns have led to new auditing standards and regulations to be formulated targeting the need for investors, regulators and auditors to concentrate on preventing and detecting such fraud and avoid the losses. A fraud is simply an act of deceiving other for personal advantage. Fraud is defined as any intentional act or omission designed to deceive others, resulting in the victim suffering a loss and/or the perpetrator achieving a gain. Regardless of culture, ethnicity, religion, or other factors, certain individuals will be motivated to commit fraud (The Institute of Internal Auditors).

All organizations are subject to fraud whereby the fraud perpetrators use deception to dishonestly make a personal gain for oneself and create a loss for another. Almost every organization suffers from fraud by the employees and in most of the cases, these frauds are not reported. This is because the fraud committed may not be of material amount. The other reason is that the entity has a reputation to uphold and by reporting fraud, it would portray a negative image of the firm in the market where the firm may end up losing the investors and the market share.

As such many frauds remain undetected. Frauds are also committed by one entity to the other where the entity may be deceived by scam policies or by scam artists. These frauds sometimes are material and are usually followed by greed where the perpetrator commits a crime in the process of hiding or destroying evidence. Moreover, fraudulent activities such as theft, corruption, conspiracy, embezzlement, money laundering, bribery and extortion are common forms of fraud prevalent in the corporate environment around the globe.

These frauds exist due to many factors but the fraud triangle explicitly and clearly describes the fraud cycle. However, the first time a person commits fraud may be due to a reason or pressure such as family’s medical bill but after not been detected or identified as fraud perpetrator, the person may take advantage of it over and over again till the time the fraud is detected by the firm or the regulators. There are many symptoms or red flags that depict a fraud taking place in an organization.

Even though the frauds committed are usually not detectable unless the fraudster confesses or by means or a whistleblower, there may be observable changes in the behaviour of the fraud perpetrator such as a sudden luxurious lifestyle. It is essential to analyze the red flags so that significant and material amounts of fraud could be avoided. Such red flags are not restricted to humans’ behavioral pattern but also the firm’s financial reports. This is because a company can be compared to a smokescreen behind which fraudulent activities flourish.

Therefore, the red flags in case of companies could be determined through external independent audits and serious matters could be resorted to a forensic accountant. Thus, this research paper is based on the analysis of the fraud triangle, the symptoms or the red flags that enable auditors to determine the existence of fraud. This paper also identifies areas of fraud and the most probable fraud perpetrators in an organization. Finally this paper recommends the possible preventative measures to reduce or avoid frauds in an entity. Literature Review

Fraud has been termed as a practice or an activity of deceiving other for a personal gain. Fraud is present in every corporate entity perpetrated by the employees, the management and executives or by outside means. The concept of fraud is more clearly described by means of thee fraud triangle which comprises of motive, opportunity and rationalization. According to (Lou, & Wang,, 2009) they conducted a research and the results provided a model for applicable proxy variable relating the fraud triangle to yield 86. 5% accuracy classifications.

They believed that supervisors can apply this model to identify firms for fraud investigation or monitoring and investors can avoid fraud risk and be assisted in investment decisions. They explained that when auditors preliminary assess new client engagement, the model can also be applied to evaluation in the likelihood of fraudulent financial statement The collapse of the major corporate governance tools to reduce financial fraud and the increasing sophisticated financial fraud has posed serious threat to investors, government, and general public (Eyisi & Agbaeze, 2007).

These authors argue that due to a lack of proper governance tools and in adequate internal controls, fraudulent activities prevail in the corporate environment. Lack of management integrity has been deemed as a red flag. (Cottrell & Albrecht, 1994) argued that red flags were neither predictive nor absolute. They describe the management’s role being insufficient of controlling every action of the employees and as such fraud is also perpetrated by the management in terms of manipulating the accounting numbers. (Apostolou, Hassell, & Sumners, 2001) researched and found that management qualities were crucial predictor of fraud.

A predictive model considering financial ratio alone is not enough. Hence, they emphasized on considering the risk factors based on the triangle to detect fraudulent reporting. In accordance with the American Institute of certified Public Accountants, (AICPA), forensic accounting services generally involve application of special skills in auditing, accounting, quantitative methods, finance, specific areas of the law, information and computer technologies research and investigative skills to collate, analyze, and evaluate evidential matter which in the forensic area is called the evidence.

It describes that forensic auditor possess expertise skill and can be called to carry out investigation on financial matter and internal controls which may be used in law court and also he can be called to act in the law court to give evidence on issues relating to financial fraud. (American Institute of certified Public Accountants, (AICPA), 2002) There are many authors that has comment on the issue of fraud and majority of the case, it was identified that it was due to lack of internal controls and lack of proper monitoring and governance.

They argued on the fraud elements and emphasized the need to identify and understand the symptoms of fraud. Review of the Fraud Triangle This review is based on the journal article published by the Chartered Institute of Management Accountants (CIMA) on the topic of “Fraud Risk Management” where the concept of deceptive conduct of fraud is discussed and the elements of the fraud triangle which is motivation/pressure, opportunity and rationalization is explained. The journal firstly defines and discusses about fraud and general effects of fraud on the business then explains the fraud triangle model.

Source: (The Institute of Internal Auditors) To begin with, the first element is pressure or incentive to commit fraud. In simple terms (Chartered Institute of Management Accountants,), it is the motivation usually based on either greed or need. Other causes included problems from debts and gambling. Many people are faced with the opportunity to commit fraud, and only a few of the greedy and needy do so. Personality and character, including how worried people are about the end results of taking risks, play a role. Some people with noble objective ethics can fall into bad peers and develop tastes for the fast life, which tempts them to fraud.

This discussion illustrates that even the management can manipulate earning to achieve management pressured goals. Secondly, the element of opportunity that is the circumstances that provide chances to commit fraud whereby fraud is more likely to be committed in companies where there is a weak internal control system, poor security over company assets, and little fear of exposure and likelihood of detection. Research has shown that some employees are totally honest, some are totally dishonest, but that many are influenced by opportunity.

Finally, the third element is rationalization which is the attitude or character that leads one or more individuals to rationally commit fraud. Many people obey the law because they believe in it and/or they are afraid of being shamed or rejected by people they care about if they are caught. However, some people may be able to rationalize fraudulent activities saying that it was essential especially when done for the business, harmless because the victim is large enough to absorb the impact and also justified because ‘the victim deserved it’ or ‘because I was mistreated.

In addition to these explanations, this journal article provided a real life example or scenario of a case in the United Kingdom. The example was of a case of the secretary Joyti De-Laurey who stole over ? 4. 3 million from her bosses at Goldman Sachs. The first element was present as the motive behind the fraud was primarily greediness of a luxury lifestyle. De-Laurey has even self-confessed that she did not steal because she needed to, but because she could. The second element was illustrated as the secretary gained the trust of her boss in terms of having access to the cheque books and forging her boss’s signature on the cheques.

The final element of rationalization was that the secretary assured herself that she deserved the money due to her dedication and that her boss had lots of cash to spare. Eventually her actions were detected and as punishment she was imprisoned for seven years in 2004. The Red Flag Areas of Fraud (Coenan)There are many red flag areas of fraud such as firstly, Structural red flags of fraud relate to the way that a company is set up and the policies and procedures that are implemented which in turn create opportunities for fraud.

Employees familiarize the operations knowing the unmonitored accounts, which areas of the company are poorly supervised, and what size of transaction that creates investigations and inquiry. Secondly, Personnel red flags of fraud refer to the employment policies and procedures within a company, including hiring procedures, promotional requirements, employee monitoring programs, and disciplinary standards. It deals with the personal characteristics and skills that the organization expects from the workers whereby hiring of under-qualified relatives in the firm may be evident.

Thirdly, Operational red flags of fraud highlight how a company does daily business. Key concerns for management usually include operational effectiveness and status, compliances with the regulations, usefulness of segregation of employees in order to divide power and control and the role of authorization. Moreover, Accounting system red flags of fraud refer to the accounting policies and the level of internal controls incorporated. An effective, secure accounting system cannot exist without internal controls as it is a means of detecting errors and frauds.

These red flags include the timing, frequency and the materiality of the transaction and reporting period and related parties. In addition, financial performance red flags of fraud include inappropriate performance measures to attain goals for both individuals and the company. The signs portraying the possibility of frauds in an organization are that company dominating the market with high competition level, having huge earnings during recession while other firms in the industry suffer losses, cash flow difficulties and consistent audit pattern adjustments over the years.

Finally, Professional service red flags are present when a company has observable difficulties in keeping an auditing firm or retaining advocates, changes banks repeatedly, or has persistent difficult relationships with professional service provider Perpetrators of Fraud The fraud perpetrators are usually the individual employees, the management or executive or even the corporate entity which may deceive the investors or the general public. However, there needs to be human involvement to commit a fraud and these persons are those with deceitful qualities or character.

A fraud may be committed by a person out of pressure as indicated by the fraud triangle model. The fraudster may have many reasons that encourages them to commit a fraud such as financial difficulties like outstanding mortgage payments, medical and housing bills and necessary items such as fees for children’s’ education. In simple terms, the fraud perpetrator may be a frustrated and helpless individual with a lot of problems in the family survival. Moreover, the perpetrators of fraud may also be a person with unethical character and values who commits fraud just for wealth in order to live a luxurious life.

These fraudsters are also encouraged to commit fraud after being undetected during the very first or initial stage of perpetrating fraud. In general, frauds are committed by humans, who are employees of a firm and are unsatisfied with the treatment of the organization, an unemployed person with a burden of financial difficulties or just a greedy person who has the desire of making personal gains at the expense of others to satisfy ones unlimited greed of power and wealth.

Fraud is only committed by person who has the opportunity and position of perpetrating a fraudulent activity. For example, the junior level staff of an entity is unaware of the tricks and experience of fraud and therefore are usually honest in their work, however, as one progresses in life and is promoted to higher position, one gains more knowledge and control of the entity and is in a position to identify weak spots in the internal control and perpetrates fraud being undetected.

The historic events in the accounting profession clearly shows that the corporate collapses of the dominating firms like Enron, WorldCom, Lehman Brothers, and Wall Street scandals were committed by the lack of strong internal control, poor governance and specifically with the direct involvement of the top executives that is those in power of control. Symptoms of Fraud Identifying the symptoms of fraud is the key to detecting fraud. A symptom of fraud may be defined as a condition which is directly liked to dishonest or fraudulent activity.

These signs of fraud enable forensic accountants to investigate and expose the fraud being committed. To begin with, some of the general symptoms of fraud are the accounting anomalies whereby the accountant is unable to match the ledgers and the trial balance, observable weaknesses in the internal controls. One of the most vital controls is the allocation of vocation so that the employees work is analyzed and check in their absence so that manipulations could be avoided by the fraudster.

Another sign is the analytical anomalies which results from the inability of the accountants and auditors to trace and match the transactions to the source. The most evident symptom the a person is perpetrating a fraud is when the person has a sudden luxurious and expensive lifestyle and acts in an unusual behavior like signs of stress when the matter of the fraud source is put up in the conversations. There is also a sign of fraud from tips and complaints such as from the whistle blowers.

Moving on, a more specific explanation on the symptom of fraud which is personal red flags relating to the lifestyle concerns is that the fraudster has noticeable lifestyle changes like clearing off long overdue financial obligations such as paying off the house mortgage or loan repayments before expected date. Signs exists when the fraudster suddenly live an expensive lifestyle and it is noticed in the appearances such and branded clothing and artifacts and expensive vehicles.

The auditors and the forensic accountants also look for symptoms of fraud in the organization which is usually identified in the accounting reports. The investigators look for evidence in the documentations of the entity in all departments as even the bookkeepers of a firm has access to confidential data and also sometimes cash due to lack of internal controls in the entity and conspiracy with other employees to commit fraud in the cash receipts for example where the deposit may be documented but not actually deposited.

The auditors or the investigators therefore analyze the strength of the internal control and corporate governance to determine the level of frauds being committed. In the absence of proper internal controls, the risks of fraud are generally high. The corporate entities also manipulate accounting data for fraudulent purposes such as using creative accounting policies to hide the liabilities to attract investors to reduce the reported earnings in order to escape tax obligations.

Some of the creative accounting policies include income smoothing, taking big bath earning and also doing insolvency trading by hiding the delicate information that may discourage investors from investing. Preventative measures Fraud affects the corporate entity even though the executives gain since those dependent on the firm like the employees suffer when the entity collapses due to fraud resulting in bankruptcy. Therefore it is essential to combat fraud so that the dependent parties avoid losses and fairness is maintained.

There is no doubt that proper internal controls play a vital role in the prevention and avoidance of fraud. Internal controls related to fraud fall into one of three categories firstly preventive controls which focus on guarding the company’s assets and in order to avoid frauds and manipulation. Secondly, detective controls that are aimed at finding fraud when it occurs to avoid future material frauds. Finally, corrective controls which attempts to rectify the problems that are discovered, so that future frauds can be better prevented and detected.

Creating a structure that prevents and avoids fraud includes drafting policies and measures that prevent fraud, and observing them to ensure compliance, management leading as role models with ethical behavior presented at all times, monitoring of personal relationships that might lead to collusion in a fraud scheme, educating employees about fraud and how to detect and prevent it, having effective physical security in place to protect assets and data.

Finally, adherence to or incorporating the internal control would avoid fraud to a major extent and therefore as a preventative measure, the audit of the internal controls and the strength of corporate governance is essential. A very reasonable preventative measure would be adapting to the provisions of the Sarbanes-Oxley Act of 2002 (SOX) which was formulated after one of the largest corporate collapse in the US which was of course the failure of Enron.

The SOX act has many internal control provisions and also has a protection of whistle blowers which would encourage the employees to report frauds and crimes in the entity or even by the entity if involved in dishonest practice whereby the stakeholders involved are the general public at large. Limitations in Fraud Detection One of the major constraints in the detection of fraud is that the frauds committed may not have a material effect or it can only be identified if confessed by the perpetrator.

It makes the evidence gathering process difficult and as such the fraud offender remains undetected. Another drawback is that the organizations fear of a reduction in market share and fall in reputation that leads entities not to disclose frauds to the statuary regulators and therefore fraudster are not punished. The difficulties arise when the employees conspire and protect the perpetrator due to fear and intimidation. The whistle blowers fear their security as the fraudsters nowadays goes beyond any limits to protect their interest and this is where a fraud is followed by a crime.

The lack of internal controls and documentation is another failure for fraud detection and these results from lack of regulatory controls and law implementations. Recommendation After the compilation of this research paper, it is evident that fraud is becoming a serious issue and the detection of the fraud is becoming very difficult that is a contributory factor of encouraging fraud perpetrators to commit frauds and is followed by crimes.

It would be strongly recommended to the organizations to implement and strictly follow the internal control procedures to uphold the corporate governance in fraud detection and avoidance. It is also noted that even though the internal procedures are present in the organization structure, it is not followed which is due to lack of implementation by the management. It would be suggested to the entities to train and educate the staff on the importance of corporate internal controls in terms of operational benefits not only to the firm but lso the employees.

Moreover, there is apparent evidence that the regulators are not involved in the implementation of the internal controls in an organization to avoid fraud. It could be recommended to the regulatory authorities to create awareness among the organizations to participate in eliminating fraud to maintain the integrity and confidence in the accounting profession. This is also to maintain investor confidence as frauds has contributed to corporate collapses in the past.

The detection of fraud becomes difficult when the evidence of fraud is destroyed by the fraudster and the employees are reluctant to report or contribute due to insecurity. It would be recommended to the government and the law enforcement authorities to incorporate provisions of protection of whistleblowers so that the employees and the members of the public is able to report dishonest practices without the fear of intimidation.