The Use of Red Flags to Detect Misconduct or Fraud

What is a Red Flag?

A Red Flag is an unusual circumstance or a pattern of anomalies that should alert a reasonable person of possible misconduct. In each such instance, further inquiry and due diligence might be necessary to determine if the anomalies are explainable and if not, an investigation should be considered.

Not every red flag means there is fraud!  Like I mentioned above, you need to seek to understand.

Below are some common Red Flags to consider.

Senior Leadership

  • Autocratic management style.
  • Distribution of authority is centralized and reserved for the top.
  • Lack of a long-term strategic plan.
  • Reporting is done by exception, rather than by routine.
  • Profit, rather than customer focused.
  • Management by crisis, rather than by objectives.
  • Overly complex financial statements.
  • Failure or inconsistent discipling of individuals that have violated company policy – could even be a double standard.

Transactions

  1. Does the transaction and its reflection in the books and records make sense?
  2. Does the person who recorded the transaction seem odd?
  3. Was there an apparent or perceived override of internal controls in order to record the transaction?
  4. Does the transaction make sense in light of the company’s operations, goals, and objectives?
  5. Does the totality of this and similar transactions make sense analytically when evaluated in comparison to the economy, the industry, key competitors, and other related accounting data within the organization?
  6. Does the transaction have proper approval and the proper authority levels?
  7. Does anything else about the transaction or its nature make it appear suspicious?

Data

  • Unusual timing of transactions: 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 organization has its own operating patterns, and the transactions should be booked accordingly.
  • Unusual amounts recorded: Take notice of whether an account has many entries that are large, round numbers. Consider whether some of the transactions in the account are far too large or far too small.
  • Questionable parties involved: Should the organization be paying an outside party? Is a payment being made to a related party? Is the company paying large sums to a vendor whose name is not easily recognizable?

Documents

  • Missing or altered documents.
  • Evidence of backdating documents.
  • No original documents available.
  • Documents that conflict with one another.
  • Questionable or missing signatures on documents.

Controls

  • Lack of controls in general.
  • Known overrides.
  • Unwillingness to remediate or long ago unremediated gaps.
  • Poor tone from the top.
  • Segregation of duties (excuse!).
  • Management with no clear position about conflicts of interest.
  • Lax rules regarding authorization of transactions.
  • Untimely reconciliation of or failure to reconcile accounts.

Behavior

  • Rationalization, changes in behavior, contradictory behavior, or recurring negative behavior patterns.
  • Lack of stability.
  • Inadequate income for lifestyle.
  • Resentment of superiors and frustration with job.
  • Emotional trauma in home or work life.
  • Undue expectations from family, company, or community.
  • Uses excuses as to why work is not completed – hides behind a crisis.

FCPA (Bribery) Red Flags

  • A high-pressure culture – hit the sales target!
  • A culture that requires entertaining of, or offering gifts to, government officials.
  • A country where business partners could also be considered government officials (such as the Saudi Royal Family) or consultants to government officials.
  • Activities requiring a high level of government interaction.
  • Personal or family relationships between employees/contractors/agents and foreign officials.
  • Unusual documentation or payment arrangements, including sizeable commissions or fees, or payments to third country bank accounts.
  • Activities in a tax haven country or a “high corruption risk” country identified on Transparency International’s Corruption Perception Index, which can be found at https://www.transparency.org/
  • Lack of substantial bona fide services to be performed by an agent or consultant.
  • Bad reputation of an agent or consultant in the local community for ethical business practices.
  • Reluctance to furnish information about business relationships with other reputable US corporations.
  • Reluctance to execute agreements containing FCPA compliance covenants.
  • Meal or gift expenditures in excess of local custom amounts.
  • Suggestion of a pay-to-play scheme, including a requirement for a payment to a charity, foundation, or other third party in exchange for a contract or other benefit to the company.
  • Government officials who lack appropriate approval authority offering to obtain approvals on behalf of the company.

Closing

I welcome your comments, suggestions, and wish everyone well!

Jonathan T. Marks, CPA, CFE

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