6/2/2023

RED FLAGS FOR

FRAUD

Introduction
Fraud
Principles

Fraud Prevention,
Possibility of
Entity Activities Detection, &
Fraud
Investigation

Fraud Scheme
and Red Flags
Fraud Risk
Assessment
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What is Red Flag?

 A red flag = a set of circumstances that are unusual
in nature or vary from the normal activity.
 Red flag = signal: something is out of the ordinary
and may need to be investigated further.
 Remember:
 Red flags do not indicate guilt or innocence, but
 warning signs of fraud.
 Just keep in mind:
 Do not ignore a red flag
 Sometimes an error is just an error

Types of Red Flags and Fraud

 Common Red flags:
 Employee Red flags
 Management Redf lags
 Specific Red flags:
 Asset Misappropriation
 Corruption
 Financial Statement Frauds
 Red flags = Fingerprints of frauds
 Fraud motives + Behavior + Fraud Scheme
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Employee Red Flags

 Lifestyle changes: expensive cars, jewelry,

homes, clothes
 Significant personal debt/credit problems
 Behavioral changes (drugs, alcohol,
gambling, or just fear of losing the job)
 Refusal to take vacation or sick leave
 Lack of segregation of duties

Changes in Behavior

 Behavior changes (“Red Flags” for

Embezzlement):
 Borrowing money from co-workers
 Creditors or collectors appearing at the workplace
 Gambling beyond the ability to stand the loss
 Excessive drinking or other personal habits
 Easily annoyed at reasonable questioning
 Providing unreasonable responses to questions
 Refusing vacations or promotions for fear of
detection
 Carrying unusually large sums of money
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Lifestyle Fraud
 Some embezzlers are secretive.
 “Aspiring” embezzlers want to use, enjoy,
share, and show off their fraudulently gained
money.
 “My husband/wife just got a great promotion.”
 “I have a few little investments that have been
doing really, REALLY well.”
 “Great Aunt Ethel passed away and I was totally
surprised – she left us quite a nice little nest egg.”
 “I finally decided to get rid of some property that’s
been in the family for years.”

Lifestyle Problem Fraud deals with

addictions
 Absenteeism
 Regular ill health or “shaky” appearance
 Easily making and breaking promises and
Series of creative “explanations”
 Inconsistent or illogical behavior
 Forgetfulness or memory loss
 Family problems
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Management Red Flags

 Reluctance to provide information to

auditors
 Engage in frequent disputes with auditors
 Decisions are dominated by an individual or
small group
 Display significant disrespect for regulatory
bodies
 Weak internal control environment
 Lax or inexperienced Accounting personnel

Management Red Flags

 Decentralization without adequate
monitoring
 Frequent changes in banking accounts
 Frequent changes in external auditors
 Company assets sold under market value
 Significant downsizing in a healthy market
 Continuous rollover of loans
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Management Red Flags

 Excessive number of year end transactions
 High employee turnover rate

 Declines in cash balances

 Refusal by company or division to use serial

numbered documents (receipts)
 Any financial transaction that does not make
sense - either common or business
 Photocopied or missing documents

Internal Control Weaknesses

 Lack of segregation of duties

 Lack of physical safeguards
 Lack of independent checks
 Lack of proper authorization
 Lack of proper documents and records
 Overriding of existing controls
 Inadequate accounting system
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RED FLAG
ASSET MISAPPROPRIATION

Red Flags in Cash/Accounts Receivable

 Excessive number of discounts and returns

 Unauthorized bank accounts
 Discrepancies between bank deposits and posting
 Abnormal number of expense items, supplies, or
reimbursement to the employee
 Excessive or unjustified cash transactions
 Large number of write-offs of accounts
 Bank accounts that are not reconciled on a timely
basis
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Red Flags in Payroll

 Inconsistent overtime hours for a cost
center
 Overtime charged during a slack period
 Overtime charged for employees who
normally would not have overtime wages
 Employees with duplicate Social Security
numbers, names, and addresses
 Employees with few or no payroll
deductions

Red Flags in Purchasing/Inventory

 Increasing number of complaints about
products or service
 Increase in purchasing inventory but no
increase in sales
 Abnormal inventory shrinkage
 Lack of physical security over assets/
inventory
 Charges without shipping documents
 Payments to vendors who aren’t on an
approved vendor list
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Red Flags in Purchasing/Inventory

 High volume of purchases from new vendors
 Purchases that bypass the normal
procedures
 Vendors without physical addresses
 Vendor addresses matching employee
addresses
 Excess inventory and slow turnover of
inventory

Red flags for billing fraud schemes

 Invoices for unspecified consulting or other services
 Unfamiliar vendors
 Vendors with PO Boxes
 Vendor name consisting of initials
 Rapid increases in purchases
 Multiple monthly billings
 Employee/vendor address match
 Consecutively numbered invoices from a vendor
 Repeated requests to expedite payments to particular vendors
 Invoice for round dollar amounts
 Delivery address other than institutional address
 Excessive returns to vendors
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Red flags for check tampering

 Altered bank statements

 Cancelled (VOID) checks do not match
physical copies of checks
 Altered check register
 Altered check disbursement journal
 Altered cancelled checks

19 // experience clarity

Red flags for skimming schemes

 Employees who do not take vacation

 Employees who do not like others to
perform their duties
 Missing register tapes or other records
 Consistent differences in register receipts
to cash on hand

20 // experience clarity
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Red flags for Expense Reimbursement

/Credit card schemes
 Purchases that do not appear to be business
 Original documents supporting expenses missing
 Receipts are altered
 Many receipts from the same vendor
 Submitted receipts are consecutively numbered
 Expenses in round dollar amounts
 Expensive business lunch/dinner expenses without
names/organizations of attendees and business
purpose noted
 Excessive use of taxis on business trips

21 // experience clarity

RED FLAGS OF
FINANCIAL
STATEMENT SCHEMES

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Types of FSF

 Fictitious revenues
 Timing differences
 Improper asset valuations
 Concealed liabilities and expenses
 Improper disclosures

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Fictitious Revenues & Timing

Difference
RED FLAGS
 Rapid growth
 Unusual profitability
 Negative CFO with positive NI
 Related party/SPE transactions
 Complex transactions
 Sales to unknown entities
 An unusual surge in sales

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Concealed Liabilities

SCHEMES: RED FLAGS

 Liability/expense  Negative CFO with positive
omissions NI

 Capitalized  Significant estimates

expenses  CEO obsession with GAAP
selections
 Warranties
 Unusual ↑ in gross margin
 Contingencies

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Improper Asset Valuation

SCHEMES RED FLAGS

 Inventory  Negative cash flows with positive
earnings.
valuation
 Declining business/economy
 Accounts
receivable  Lots of assets based on estimates

 Business  CEO obsession on GAAP choices

combinations  Gross margin ↑ compared to industry
 Fixed assets  ↓Allowances for bad debts, inventory
 Unusual change in the relationships
 Increasing assets when competitors are
reducing
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Improper Disclosures
 Liability omissions
 Subsequent events (legal
contingence)
 Management fraud
 Related-party transactions
 Accounting changes

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Red Flags – Improper Disclosures

 Domination of management
 Ineffective board of directors
 Tone at the top
 Rapid growth or unusual profitability
 Known history of violations
 Materiality justifications
 Limitation of auditor access

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Red Flags – Improper Disclosures

 Significant, unusual, or
highly complex
transactions,
Tax Haven Countries
 Significant related-party
1.Switzerland
transactions
2.Cayman
 Overly complex Islands
organizational structure 3.Hong Kong
4.Singapore
 Tax haven bank 5.Luxembourg
accounts 6.Guernsey
7.Panama
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Corruption
 Off book fraud hard to detect
 Payment often do not through acct record
 Payment often paid in cash
 By passing normal contracting procedure
 Missing document or record regarding
meeting or decision
 Unexpected or illogical decision accepting
projects or contract
 Unfavorable contract or terms
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Corruption Red flag

 Look for behavioral red-flag
 Too close a relationship between employee
and vendor
 Unexplained preference for particular vendor
 Acceptance of lavish gift/trips
 Pressure for payment to be made urgently or
ahead of schedule
 Credit problems
 Addictive problems (gambling)

FINAL NOTES
 Dr. Edmond Locard’s formula in forensic
science: "Every contact leaves a trace".
 The Trace = red flags
 Red flags are warning but do not always
indicate guilt or innocence
 Need further investigation
 Need to understands red flags of:
 Asset misappropriation
 Corruption
 Financial statement frauds