2. WHAT IS RED FLAG?
Red Flags are sign or warning
of any impending danger or
inappropriate behaviour.Red
Flags do not necessarily
indicate the existence of fraud
however are indicators that
caution needs to be exercised
while investigating the
situations.
A normal accountant act like the
policeman the forensic investigator
role is akin to the CID/CBI and looks
for signs which indicate abnormal
and unusual behaviour.Such signs
are referred to in forensic
accounting parlance as red flags.
3. TYPES OF RED FLAGS
They include aggressive goals and performance
measures.
Financial
performance red
flags
They refer to the organization of the accounting system
and the level of internal controls that are in place.
Accounting
system red flags
They highlight how a company does business each
day.
Operational red
flags
They include behavioural patterns of the employees.
Behavioural red
flags
They relate to the way that a company is set up and the
policies and procedures that are in place.
Structural red
flags
They refer to the employment policies and procedures
within a company
Personnel red
flags
4. FINANCIAL PERFORMANCE RED FLAGS
• Significantly outpacing
competitors in the industry
• Outstanding results when the
rest of the industry has
suffered a downturn
• Unusual financial ratios when
compared to competitors
• Persistent cash flow problems,
even when the company has
regularly reported profits
• A pattern of similar audit
adjustments proposed year
after year
When a certain level of
performance is
mandated, by the boss,
Investors,the bank, or
otherwise, there can be
a temptation to turn to
fraud to meet these
goals. Companies
whose financial
performance suggests
the possibility of fraud
might include some of
these signs:
5. ACCOUNTING SYSTEM RED FLAGS
They refer to the
organization of the
accounting system
and the level of
internal controls
that are in place. A
good, secure
accounting system
cannot exist
without internal
controls, and the
company cannot
be free from error
and fraud without
such controls.
Some of the basic
red flags that
might be noted in
a company’s
accounting
records include:
Unusual timing of the transaction.This includes the time of day, the day of
the week, or the season.
Frequency of transactions.Transactions that are occurring too frequently
or not frequently enough are suspicious. Each company has its own
operating patterns,and the transactions should be booked accordingly.
Unusual amounts recorded.Take notice of whether an account has many
large, round numbers entered. Consider whether some of the transactions
in the account are far too large or far too small.
Unusual amounts recorded.Take notice of whether an account has many
large, round numbers entered. Consider whether some of the transactions
in the account are far too large or far too small.
Questionable parties involved. Payment being made to a related party? Is
the company paying large sums to a vendor whose name is not easily
recognizable or is not a normal vendor of the company
6. OPERATIONAL RED FLAGS
They highlight how a company does
business each day. Do things run smoothly,
minimizing the chance for errors and
problems? Or are things managed in such a
fashion that errors go unchecked and
employees do whatever they want, whenever
they want?
7. BEHAVIOURAL RED FLAGS
• In “Report to the nations on occupational Fraud and Abuse’ by ACFE
identified the behavioural indicators displayed by Fraud
Perpetrators.The below figure shows the distribution of those red
flags. Approximately 44% of fraud perpetrators were living beyond
their means while the fraud was ongoing, and 33% were
experiencing known financial difficulties. Other common red flags
were an unusually close association with a vendor or customer
(22%), displaying control issues or an unwillingness to share duties
(21%), a general“wheeler-dealer”attitude involving shrewd or
unscrupulous behaviour (18%), and recent divorce or family
problems (17%).These six red flags were also the most common
behavioural indicators in each of ACFE’s last three studies.
They include behavioural patterns of the employees.
8. STRUCTURAL RED FLAGS
They relate to the way that a
company is set up and the policies
and procedures that are in place.
Those very systems create
opportunities for fraud each day.
Employees become familiar with
operations, and they begin to
understand what accounts are
unmonitored, which areas of the
company are poorly supervised,
and what size of transaction that
creates added scrutiny.
9. PERSONNEL RED FLAGS
• They refer to the employment policies and
procedures within a company, including
hiring procedures, advancement policies,
employee monitoring programs,and
disciplinary standards.
10. APPENDIX 3 OF SA 240
THE AUDITOR’S RESPONSIBILITIES RELATING
TO FRAUD IN AN AUDIT OF FINANCIAL
STATEMENTS’contains examples of certain
Red Flags i.e. examples of circumstances that
may indicate the possibility that the financial
statements may contain a material
misstatement resulting from fraud.
11. INDICATIONS OF MATERIAL MISSTATEMENT
RESULTING FROM FRAUD
Discrepancies in the
accounting records
• Unsupported or unauthorized balances or transactions
• Last-minute adjustments that significantly affect financial results
• Tips or complaints to the auditor about alleged fraud.
Conflicting or missing
evidence
• Missing documents
• Documents that appear to have been altered
• Unusual discrepancies between the entity's records and confirmation
replies
• Significant unexplained items on reconciliations
Problematic or unusual
relationships between
the auditor and
management
• Undue time pressures imposed by management to resolve complex or
contentious issues
• Unusual delays by the entity in providing requested information
• An unwillingness to address identified deficiencies in internal control
on a timely basis.
Others
• Accounting policies that appear to be at variance with industry norms
• Tolerance of violations of the entity’s code of conduct.
• Frequent changes in accounting estimates that do not appear to result
from changed circumstances
12. INDICIA OF FRAUD
• Lack of Corporate Governance.
• Questionable Accounting Activities
• Sudden Losses
• TGTBT syndrome.
• Generation of ‘orphan’ funds
• Disaster situations
• Missing Documentation
• Chaotic conditions
• Behavioral Issues
• Complaints
Red flags that are
“Indicia of Fraud”
are nothing but
symptoms or
indicators of
situations of frauds.
They do not
necessarily indicate
the existence of
fraud and hence the
auditor should
exercise caution in
forming an opinion
before investigating.
13. LACK OF CORPORATE GOVERNANCE
Absence of rotation
of duties or
prolonged
exposure in the
same area
no written policies
and/or procedures
lack of Internal
Controls or casual
approach to
reported internal
control lapses
frequent or unusual
Related Party
transactions ( not
arm’s length)
Close nexus with
vendors, clients, or
external parties -
There would be a
conflict of interests
if an employee,
particularly at a
senior level, were
to have close
relations with a
client.
14. Questionable Accounting Activities
Management override of
Internal Controls
unreconciled subsidiary &
General Ledger accounts
continuous adjustments of
book to physical inventories
topside Journal Entries
Excessive number of
manual checks
15. A company doing quite well
suddenly makes huge losses.
While there could be genuine
reasons, mismanagement of
funds and resources are more
likely.These losses are likely to
have been there all along
simmering under window
dressed accounts.
SUDDEN LOSSES.
16. TGTBT SYNDROME
TGTBT stands for Too
Good To Be True. This
indicates that lovely
glossy report may be
furnished whereas in
real terms there are
gloomy conditions.
17. Accidents where books have
been lost, or damaged, or
catastrophes such as fire,
earthquake, floods etc. are
other places where fraudsters
can feast.
Disaster situations
18. Generation of ‘orphan’ funds
Funds which are held in a fiduciary capacity and for
which there is no accountability are thriving places for
frauds. Funds collected by trusts or donations in cash
collection boxes are typical examples where there is
no accountability on either side. Neither does the
donor concern himself about the usage of the funds
nor does the beneficiary have a direct claim or even
awareness in respect of such funds. However such
funds can Familiarization with Red Flags in Detection
of Frauds.
19. MISSING DOCUMENTATION
This is the surest sign of fraud and practically
every situation of missing records either has been
created to suppress a fraud or if such a situation
happens to emerge it is used to engineer a fraud.
20. Chaotic conditions
As a corollary of disaster situations, conditions
where accounts are in arrears, messy state or
unreconciled, by and large are artificially created.
The reason given normally is shortage of staff or
resources, but this is more of an excuse.
21. Complaints
Frequently tips or complaints will be
received which indicate that a
fraudulent action is going on.
Complaints have been known to be
some of the best sources of fraud and
should be taken seriously. Although all
too often, the motives of the
complainant may be suspect, the
allegations usually have merit that
warrant further investigation.
22. BEHAVIOURAL ISSUES
failure to take vacations
living beyond one’s means
Insider trading
early arrival – late departure
Irrational behavior
23. YELLOW FLAGS
These are indications of
authorized activities which are
flagged because of their unusual
nature.These may be perfectly
legitimate activities which are
worth checking as they may also
be indications of fraudulent
activity. Examples of such
activities are
• Unusually high transactional
amounts on a debit credit
card transaction
• Login to a system or
application from an unusual
IP or Location
Such transactions are used to enforce preventive
measures or exception reporting e.g. Banks now call
up the card holder to verify if high volume transactions
or transactions from a different location or a foreign
location are genuine before authorization
24. Green Flags are in many ways the converse of Red Flags.
They are a part of the TGBT syndrome referred to earlier.
(TOO GOOD TO BE TRUE). Examples include
• Unusually high returns provided by an investment
• High Profit Margins for a company which are way above the industry
average
• Specific companies performing very well when the industry is in a slump
Like Red Flags these are only indicators and are not
conclusive evidence of fraudulent activity and need to be
investigated before reaching a conclusion.
