The Fast Close Toolkit

CHAPTER THIRTY FOURAnalytics to Detect Financial Statement Fraud

INTRODUCTION: FINANCIAL STATEMENT FRAUD, commonly referred to as “cooking the books,” involves deliberately overstating assets, revenues, and profits and/or understating liabilities, expenses, and losses. A business that engages in such a practice stands to lose a tremendous amount of money when penalties and fines, legal costs, the loss of investor confidence, and reputational damage are taken into account.

Red flags are events, conditions, situational pressures, opportunities, or personal characteristics that may cause management to commit fraud on behalf of the company or for personal gain. They can be used as an early warning system by both auditors and other stakeholders to assess the risk of fiscal statement fraud. Although red flags may not necessarily indicate the presence of fraud, they are conditions believed to be commonly present in the event of fraudulent activities and may therefore warrant concern and additional investigation.

In the past red flags were addressed from the perspective of the auditors. The problem is that the red flags identified by auditors are not necessarily relevant to lenders and investors. Lenders and investors require red flags that are appropriate to their particular interests and their access to information on the company and its management. It is also lenders and investors who may take legal action against auditors and management based on their perception of negligence in ...