The Master Guide to Controllers' Best Practices, 2nd Edition

CHAPTER 15.FINANCIAL STATEMENT FRAUD

There are specific red flags of financial statement fraud that are present in many violations. They include the following:

• Complex or unstable organizational structure.
• Unusually intricate or confusing financial transactions with third-party entities.
• Sudden or gradual increase in gross margin compared with the company’s prior performance, and with industry averages.
• Cash flows that are negative for the first three quarters and suddenly positive for the fourth quarter—not by a small amount, but by more than all losses to date.
• Significant sales to companies or individuals whose identity and business track record are questionable.
• Sudden above average profits for specific quarters.
• Executives or board members who have direct personal dependence on the company’s performance.
• Conspicuously lax Board oversight of top management.

To reduce the risk of having financial statement frauds occur—or continue undetected—auditors should use such practices as the following:

• Horizontally and vertically analyze all financial reports;
• Conduct frequent ratio analysis, including assessment of trends over periods of several years;
• Use Beneisch’s Ratios, which pinpoint anomalies in year-to-year measures of gross margins, sales growth, receivables levels, and other key accounting ratios; and
• Rigorously apply the guidance of SAS 99 to all audit exercises.

This chapter examines the categories of fraud and offers strategies to prevent them. The following items ...