Numerous signs can point to the possibility of fraud. Literally hundreds of different types of fraud schemes exist, so the number of possible red flags of fraud is huge. Today we’ll talk about one area where you may see some red flags: irregularities in the accounting records and procedures.
Irregularities that point to the possibility of fraud can range from simple things like unreconciled accounts and unusual account balances to more complex problems like “on top entries,” which are made after the books are closed in order to manipulate the numbers ultimately reported on the financial statements.
An auto dealership had a controller who had not reconciled the bank accounts for nearly a year, despite management’s insistence that it be done. Management did not insist enough, and the problem persisted; the accounts remained unreconciled month after month. Unreconciled bank accounts usually signal one of two problems: the accounting staff is incompetent or understaffed, or there is a fraud-in-progress that will likely be exposed through a bank reconciliation. Both of these problems need to be corrected quickly.
In this case, it turned out that the controller simply couldn’t handle all of the responsibilities of her job. She was out of her league and was not doing the reconciliations because she did not have time and was likely afraid that the reconciliations would expose her incompetence. The reconciliations would have shown that she didn’t have a good handle on the company’s finances.
The auto dealership was lucky in this case. They simply dismissed the controller and hired someone more experienced and more competent. But there was a period of time during which management was afraid a fraud had occurred. They should have recognized early on that the unreconciled accounts were a sign of a big problem.
Cynthia Cooper, head of internal audit at WorldCom, recounts the “on top entries” problem that she and her team discovered were part of a massive fraud scheme at the company. Executives were directing employees to make journal entries “on top” of the regular general ledger activity to make the financial statements conform to a predetermined template. Lower level employees did not see these entries, because they occurred outside the regular system of recording accounting details, so the practice went on for a long time before it was discovered.
To further confuse anyone who might look at the on top entries, executives directed a web of confusing entries to be made. They were not a handful of simple debits and credits. There were hundreds of entries, with figures divided and bounced between many different accounts, apparently in an attempt to discourage anyone who might try to dig into these entries. The existence of these entries was discovered because of some irregular numbers and account names by the internal audit team. This demonstrates the importance of being on the lookout for unusual accounts, numbers, and descriptions within the accounting system.
It’s not always easy to spot accounting irregularities. After all, an employee or executive who engages in fraud is often aware of what others are expecting their work or their numbers to look like. In many companies, management knows that revenue and expenses are expected to fall within certain parameters. Numbers outside of those expectations might raise suspicions. So a good fraudster will ensure that the numbers do not appear unusual in that regard. It’s only when someone digs deeper that the irregularities start to surface. An examination of a public company’s Securities and Exchange Commission (SEC) filings might reveal some notes or disclosures that do not make sense in light of the numbers reported. Small clues like these will be necessary to point to irregularities.
For example, suppose a company reports in the notes to the year-end financial statements that the raw materials used to make its products have become significantly more expensive. An examination of the company’s gross profit margin, however, shows that the percentage is stable. The only legitimate way for the gross profit percentage to remain unchanged during a period in which raw material prices increase significantly is for the sales price of the goods to rise proportionately. The sales prices at this company did not change, however, so that immediately raises a red flag about that unchanged gross profit margin. The numbers reported don’t make sense in light of the information provided in the notes. This should definitely be examined further.
It is clear that the accounting irregularities giving rise to a fraud investigation may not be easily identifiable. Those committing financial statement fraud are often adept at covering their tracks, so the red flags are not always obvious. The investigator often relies on her or his intuition when examining the numbers and explanations for possible irregularities.