Detecting Financial Fraud and Potential Red Flags

It was recently reported that the FBI opened more than one thousand inquiries into possible Ponzi schemes during 2011. The SEC continues to launch new investigations and examine companies and individuals suspected of committing fraud. Even in the aftermath of the largest Ponzi schemes ever to occur, investors and institutions alike must remain aware that fraud is still prevalent. Fraud affects everyone-individual investors, institutional investors, bankers, investment banks and tax payers. Often the legal wrangling drags on for many years after a fraud is initially uncovered. This can end up costing all of the parties involved a tremendous amount of money. These costly fights can be avoided by acting early and taking a few additional steps in reviewing the financial information provided by a company.

As the economy strengthens, many economists and accountants are wary that investors and institutions will forget about the importance of fraud detection. Too often red flags or warning signs are present but overlooked allowing a perpetrator to continue to carry out a fraudulent scheme.

Revenue Recognition

One of the most common ways that fraud shows its face is when recognizing revenue. Fraudsters try to use different methods to inflate revenue and mislead the market. Investors and institutions must be aware of these methods. One simple comparison that can be made is to look at the financials of a company to see if an increase in revenue corresponds to an increase in the cash flow of a company. If these increases do not correspond, it may be worth taking a closer look into the components of the increase. Also, accountants can look out for significant, unusual or highly complex transactions, particularly those that are completed near the end of a financial reporting period. Another red flag related to revenue recognition can be a visibly strong growth in revenue without a tangible explanation, especially when peer companies are experiencing significant decreases. It also must be noted and remembered that it is extremely rare for any organization to experience sustained growth for an extended period of time without slight dips. Additionally, the market must pay attention to earnings growth if other factors are trending negative. For example, if there are consistent negative cash flows from operations or shrinking percentages of returns, warranty claims, etc. it would not make sense to see consistent growth, especially if it is out of line with industry peers.

Expenses and Capitalization of Costs

Investors and analysts must also understand the methodology that a company uses to calculate its expenses. There are specific principles in generally accepted accounting principles (“GAAP”) for the manner in which items must be classified. Companies are required to book expenses as they incur them. Improper accounting for these items can help manipulate the earnings of a company by holding expenses and then booking them in future periods. Also, if a company would like to fraudulently increase its net income for a period, it could classify a typical expense differently so that it falls under a separate category as prescribed by the appropriate accounting principles, which would require the cost to be capitalized over time. This item would then not appear on the income statement thereby reducing gross income. On the other hand, if a company is doing very well for a period of time and is reporting excess income during good economic times, they may want to expense an item that should be capitalized to take a one time hit on their books.

Internal Controls

Internal controls are a major component within the structure of the accounting department at an organization. This encompasses a broad area of oversight that is meant to ensure the integrity of the financial information and maintain management policies through an organization. All organizations must have an appropriate level of internal controls regarding cash management. There must be proper segregation of duties and dual signatories on any cash movement. It could be considered a forewarning of fraud if these two simple rules are not in place. Similarly, if there is not adequate monitoring of the cash management system and various parties/ affiliates all have access to the same system and accounts, a breeding ground for fraud could begin to take shape. If there seems to be frequent changes in bank accounts, a further look is also needed to ensure that something suspicious is not taking place.

The red flags briefly discussed above are just a few examples of things to pay attention to when reviewing financial information. There are many more warning signs Kinetic Partners reviews and detects for its clients in various markets around the world. We live in a world where greed remains a part of the capital markets and unfortunately, where there is greed there is fraud. It can be quite helpful to know that just a few steps can be taken to help detect suspicious activity and help a company from losing millions or even billions of dollars.