Fraudulent financial reporting

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FRAUDULENT FINANCIAL REPORTING:

DO RED FLAGS REALLY HELP?

Mohamed Abd El Aziz Hegazy1, Rasha Kassem2

1Professor of Accounting and Auditing, American University in Cairo (AUC)

2Assistant Lecturer in Accounting and Auditing, E-Learning officer, Faculty of Business Administration,

Economics, and Political Science, British University in Egypt (EGYPT)

E-mails: [email protected], [email protected]

ABSTRACT

Purpose – Aims to determine whether red flags can be helpful for external auditors in detecting fraudulent

financial reporting. The research explores whether external auditors demographic factors affect external auditors’

perception about the ability of red flags to detect fraudulent financial reporting in Egypt.

Design/methodology/approach – Data was collected using a questionnaire that was pretested by a pilot

study. A questionnaire was then distributed to a sample of 100 external auditors working in different audit firms in

Egypt and having different years of experience. The sample of external auditors was randomly selected.

Findings – According to external auditors’ opinion, red flags are helpful in detecting fraud. Our research

didn’t support the effect of external auditors’ experience and type of audit office on auditors’ perception about red

flags ability to detect fraudulent financial reporting.

Research Limitations – two external auditors from the big 4 international audit firms filled in the

questionnaire, thus our results can’t be generalized to all audit firms in Egypt. There can also be other red flags in

the literature that aren’t mentioned in the research study.

Originality/value - Our research included a list of specific red flags for fraudulent financial reporting that

were highly accepted by the sample of external auditors in our study. These specific red flags can be used in

conjunction with SAS 99 red flags to enhance external auditors’ ability in detecting fraudulent financial reporting.

The research also ranked all red flags for fraudulent financial reporting according to their relative importance based

on external auditor opinion which can help auditors to focus their efforts more on high quality red flags during

brainstorming sessions which will in turn facilitate fraud detection. Future research should be more directed toward

listing other red flags for fraudulent financial reporting in the literature and should test them using other methods

like experiments or interviews. The list of red flags presented in our research can for a good base for future

researchers.

Key words: fraud, fraud detection, fraudulent financial reporting, red flags, auditing standards

1. INTRODUCTION

Over the past decade, there were numerous examples of fraud cases and alleged auditor negligence such

as the case of Enron/Arthur Andersen, Xerox/KPMG, and WorldCom/Arthur Andersen. For many people, scandals

taking place in companies such as Enron and WorldCom in the USA are synonymous with “fraudulent financial

reporting”. In many cases against auditors, the auditors failed to obtain appropriate evidence or failed to recognize

and follow up on red flags during the audits (Kalbers; 2007; P.1). Historically, external auditors have counted on

internal control as the main defense against fraud, but this cannot only work by itself as managers themselves can

override controls. Fraud can be divided into three main categories as mentioned by (ACFE: 2008, P.5): Asset

misappropriation, fraudulent financial reporting, and corruption. However, in our research the focus will be on

fraudulent financial reporting because as stated by the ACFE report (2008; P.6), financial statement fraud is the

most costly type of fraud where it caused a median loss of $2 million. Besides, fraudulent financial reports can have

a substantial negative impact on a company’s existence as well as market value.

This study has several objectives. First, it seeks to determine whether red flags listed by SAS 99 can help

external auditors in detecting fraudulent financial reporting. Second, it seeks to determine whether red flags that

were not mentioned in SAS 99 but mentioned in the audit literature can also be helpful in detecting financial

statement fraud. Third, identifying the most important red flags as perceived by external auditors in Egypt, and

finally, it explores whether auditors demographic factors (e.g. type of audit office and auditors experience) might

affect auditors’ perception of the relative importance of red flags in general. Our research paper is organized as

follows; the first section includes the review of the literature along with the development of the research

hypotheses, then research method and data collection are described in the second section while the research data

analysis and results are presented in the third section and finally the research summary and conclusion are

included in the fourth section.

2. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT

To serve as the cornerstone of its anti-fraud program, the Auditing Standards Board of the American

Institute of Certified Public Accountants (AICPA) issued SAS No.82: consideration of fraud in a financial statements

audit that was then superseded by SAS No.99: consideration of fraud in a financial statements audit.

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SAS no. 82 requires the auditor to specifically assess the risk of material misstatement of the financial

statements due to fraud in every audit. It describes two types of fraud — fraudulent financial reporting and

misappropriation of assets. The auditor is not expected to assess the risk of fraud as high, medium or low, as might

be the case in assessing control risk. Rather, SAS no. 82 asks the auditor to consider risk factors relating to

fraudulent financial reporting and misappropriation of assets. It also provided examples of fraud risk factors that,

when present, might indicate the presence of fraudulent financial reporting or misappropriation of assets. However,

as stated by the American Institute of Certified Public Accountants (2007; P.6), SAS No. 82 focused on a typical list

of fraud risk factors that, in practice, were usually reduced to a checklist that individual auditors completed without

practical application and included in their working papers. Thus, SAS 99 superseded SAS 82. Although the

auditor’s responsibility for detecting fraud has not changed from SAS No.82, as stated by Casabona, and Grego

(2003; p.3), SAS No.99 provides more guidance on how the auditor should plan and perform the audit to obtain

reasonable assurance about whether or not the financial statements contain material misstatements because of

errors or fraud. SAS No. 99 identifies red flags as risk factors and categorizes those risk factors in three conditions

for fraud arising from fraudulent financial reporting and misappropriations of assets. These conditions are referred

to as the fraud triangle and they are: incentives/pressures, opportunities, and rationalization/attitudes.

SAS 99 introduced a new audit procedure which is a brainstorming session that must be performed on

every engagement. In brainstorming sessions, audit team members discuss how and where they believe the

entity's financial statements might be susceptible to material misstatement due to fraud. They should also discuss

how management could perpetrate and conceal fraudulent financial reporting. The quality of the red flags on the

final list produced as a result of the brainstorming session could be more important than the overall quantity of the

ideas listed. However, SAS 99 didn’t mention how auditors can decide on the quality of red flags for fraud. In our

research a list of red flags for financial statement fraud will be presented and arranged according to their likely

hood of occurrence thus, reducing the time that auditors would take in brainstorming less important red flags.

Furthermore, the PCAOB was also concerned about the role of auditors in detecting fraud as it requires

changing the nature, timing and extent of auditing procedures needed to address identified risks of material

misstatement due to fraud. The changes that are described by the PCAOB include; the nature of auditing

procedures may require obtaining evidence that is more reliable or verifiable, the timing of substantive tests might

need to be adjusted, the extent of the procedures employed should reflect the assessment of the risk of material

misstatement due to fraud (PCAOB; 2007; P.2-6). Moreover, Apostolou and Crumbley (2008, PP.1-4) mentioned

that, International Standards on Auditing No. 240 provides similar directions to auditors as its American counterpart

SAS 99 with respect to fraud. Both present specific requirements for auditors to follow like; considering a

company's internal controls and procedures, and how these are actually implemented when planning the audit,

designing and conducting audit procedures to respond to the risk that management could override internal controls

and procedures, identifying specific risks where fraud may occur, considering whether any misstatement uncovered

during the audit may be indicative of fraud, obtaining fraud-related written representations from management, and

communicating with appropriate managers and the board if the auditor finds an indication that fraud may have

occurred.

In summary, the above standards show that the efforts of standards’ setters were directed toward

narrowing the expectation gap through increasing auditors’ responsibility for detecting fraud, however in fact

regardless of these efforts, the expectation gap still exists. This is supported by what Chemuturi (2008, p.20)

mentioned in his research where he believes that current professional standards and authoritative guidance require

auditors to provide reasonable assurance that financial statements are free from material misstatements, whether

caused by errors or fraud. However, the lack of a commonly accepted definition of reasonable assurance along

with limitations of audit methods in identifying fraud, cost constraints of audits, and high expectations by investors

have widened the expectation gap regarding auditor responsibility for detecting fraud. Also, Albrecht, Albrecht, &

Albrecht (2008, PP.2-12) stated that the new standards have helped auditors better detect fraud as they became

more proactive in brainstorming possible frauds, working with audit committees and management to assess fraud

risks. However, auditors are not trained in determining when people are telling the truth or are being deceptive,

when documents are real or forged, whether collusion is taking place, or whether fictitious documents have been

created, thus their research showed that auditors still need guidance in the area of fraud detection.

In addition to that, one of the primary criticism of SAS 99 as found in Wikepedia (2010, p.1) is that; Many

procedures are suggested rather than required. For example, it is suggested that auditors consider surprise

procedures like showing up unannounced for an inventory count. In actual practice auditors often tell clients which

inventory locations they are going to ‘observe.’ Telling clients which locations are going to be audited makes it easy

to commit inventory fraud. Another criticism is that SAS 99 doesn’t close expectation gaps. The guidelines and

suggestions provided in the standard increase expectations on the profession. As a result, auditors must consider

the requirements of SAS 99 as the minimum level of work required to detect fraud. They must be prepared to

defend any decision not to pursue one of the recommended procedures listed in SAS 99.

On the Other hand, fraud in general and financial statement fraud in particular was a priority in most of the

academic research. The ACFE (2008, p.2) classified fraudulent financial reporting into five main categories which

are; revenue recognition, timing difference, concealed liabilities and expenses, improper disclosure, and improper

asset valuation. Some researchers talked about the different types of fraudulent financial reporting and red flags

that can be associated with such scheme such as Albrecht (2006; P.3) where the main findings showed that the

most common accounts manipulated when perpetrating financial statement fraud are revenues or accounts

receivable. He introduced a number of specific revenue-related exposures that need to be considered by external

auditors while auditing their clients because these exposures are the various fraud schemes that can be used to

misstate the financial statements. Examples for such fraud schemes are; Recording fictitious sales, recognize

revenues too early, or overstate real sales, or understating allowance for doubtful accounts, thus overstating

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receivables, or not recording returned goods from customers or recording returned goods after the end of the

period. Besides, not writing off uncollectible receivables or write off uncollectible receivables in later periods or

record bank transfers as cash received from customers or manipulating cash received from related parties, and not

recognizing discounts given to customers.

Besides, the Committee of Sponsored Organization of the Treadway Committee sponsored a study in 1997

and found that over half of all financial statement frauds involved revenues or accounts receivable accounts and

that recording fictitious revenues was the most common way to manipulate revenue accounts. It also reported that

recording revenues prematurely was the second most common type of revenue-related financial statement fraud. In

addition to that, Hogan et al (2008; P.242 as cited in Beasley et al 2000) stated that, “common revenue fraud

techniques include sham sales, false confirmations, premature revenue recognition before the terms of the sale are

completed, modified terms through side letters, improper cutoff, unauthorized shipments, and consignment sales”.

Moreover, the American Institute of Certified Public Accountants (2007; P.3) has found that, the third type of

fraudulent financial reporting which is concealed liabilities and expenses, is much easier to commit than falsifying

many sales transactions. Missing transactions are generally harder for auditors to detect than improperly recorded

ones because there is no audit trail and that there are three common methods for concealing liabilities and

expenses which are: Liability/expense omissions, capitalized expenses, and Failure to disclose warranty costs and

liabilities. It gives examples of fraud schemes involving concealed liabilities like; record payable in subsequent

period, or not recording purchases, or overstating purchase returns & purchase discounts, not accruing liabilities or

Record accruals in later period, not recording warranty liabilities or under-record liabilities or recording deposits as

revenues or Not record repurchase agreements and commitments. Besides, borrowing from related parties or not

recording contingent liabilities or recording contingent liabilities at too low an amount.

Also, Wells (2005, P. 119) mentioned how improper disclosure scheme can take place as a form of

fraudulent financial reporting and provided examples of this scheme. He mentioned that improper disclosure

involves liability omissions, subsequent events, management fraud, related party transaction, and accounting

changes. Examples for liability omissions include failure to disclose loan covenants or contingent liabilities. On the

other hand, Hogan et al (2008; P. 244 as cited by Gordon et al; 2007) provided a summary of research on related

party transactions and find that the mere presence of related party transactions does not appear to increase auditor

risk assessments; however the research also suggests that related party transactions is one of the top reasons

cited for audit failure when a fraud does occur. Besides, Beasley et al (2001; P.4) investigated 56 firms whose

auditors were subject to actions by the SEC, for their association with fraudulent financial statements and found

that 27 percent of their sample firms had instances where the auditor had either failed to recognize or disclose

related party transactions which in turn translated into reporting of inflated asset values.

Improper asset valuations, however, as stated by Wells; (2005, P.89) usually fall into one of the following

categories: inventory valuation, accounts receivable, business combinations (such as mergers and acquisitions),

and fixed assets. He included some examples of fraud schemes involving misstating assets accounts such as;

Overstating asset costs with related parties or not recording depreciation or collusion with outside parties to

overstate assets e.g.; allocating inventory costs to fixed assets or Using market values rather than book values to

record assets or having the wrong entity is the purchaser or allocating costs among assets in inappropriate ways or

recording fictitious assets or inflating the value of assets in intercompany accounts or transactions, or Misstating

marketable securities with the aid of related parties or misappropriation of cash resulting in misstated financial

statements without management’s knowledge, or Covering thefts of cash or other assets by overstating receivables

or inventory. One of the major forms of assets misstatements is inventory fraud that has been such a significant

problem historically in many companies because if cost of goods sold is understated, net income will be overstated

by an equal amount. As stated by Albrecht et al (2006; P.8);

Cost of goods sold can be understated by understate purchases, overstate purchase returns, understate

purchase discounts, or overstate ending inventory. Among these alternatives, overstating end-of-period inventory

tends to be the most common because it not only increases net income, but also increases recorded assets and

makes the balance sheet look better.

A good number of academic research were also concerned about the effectiveness of red flags in fraud

detection such as what Silverstone and Michael stated below:

The most important qualities the accounting professional can bring to any fraud investigation are an

investigative mindset and skepticism. The skeptical mindset is something that has long been inherent in forensic

accountants and other internal investigators when looking for evidence of fraud. With the emergence of SAS 99

and under increasing scrutiny, the external auditor is now being pushed to think like the forensic accountant which

means to think like both a thief and a detective and be constantly looking for the weak links in the accounting

system and among the people who staff it. What turns a well-trained and experienced accounting professional into

a good financial investigator is the knowledge of human behavior and a sixth sense for red flags for fraud and a

good intuitive feel for the significance of evidence. (2007, PP.61-62)

Besides, the ACFE’s report to the nation on occupational fraud and abuse that was published in (2008, P.9)

included some examples of the top 10 red flags of fraud such as: living beyond the person’s means, financial

difficulties, control issues and unwillingness to share duties, divorce/family problems, unusually close association

with vendor/customer, irritability, suspiciousness or defensiveness, addiction problems, past legal problems, and

past employment problems. Another research that was carried by Bossard and Blum (2004; P.2) introduced real life

fraud cases such as the case of WorldCom that overstated its reported income by approximately $9 billion and

WorldCom was able to both strengthen its balance sheet and improve its net income through this fraud. The

authors mentioned that this fraudulent financial reporting could have been detected using red flags like; journal

entries may be recorded without supporting documents or accounting rationale, entries are made in round dollar

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amounts and booked late in the closing process. Entries may also be reversed and rebooked for a different amount

or posted by unusual personnel.

Moreover, Vicky, B., Hoffman, H., Morgan, K., and Patton, J. (1996) supported the use of red flags in fraud

detection where they stated that knowing the most important warning signs should help auditors do a better job of

assessing fraud risk. They also mentioned that while current and proposed auditing standards require auditors to

make this assessment, they don’t provide guidance on the relative importance of particular signs. By seeing which

factors other auditors considered to be the most important, practicing auditors can assess the risk of fraud in their

own audit engagements more efficiently and consistently. Their paper listed some red flags for fraudulent financial

reporting such as managers have lied to the auditors, the auditors’ experience with management indicates a

degree of dishonesty, management has engaged in frequent disputes with auditors, the client has engaged in

opinion shopping and management places undue emphasis on meeting earnings projections or other qualitative

targets.

On the other hand, studies examining the use of questionnaires or checklists in assessing fraud risk have

found mixed results. In one of the first studies in this area, Pincus (1989; P.1) examines the efficacy of a red flags’

questionnaire for assessing the risk of material fraud of a client using 137 auditors as subjects. Her findings

suggest that the use of a questionnaire was dysfunctional for the fraud case where questionnaire users assessed

the fraud risk to be lower than nonusers. While Glover et al (2003; P.4), find support for the use of questionnaires

by comparing pre and post SAS No.82 planning judgments. The authors find that post SAS No.82 judgments are

more sensitive to fraud risk factors. For instance post SAS 82 participants are more aware of the need to modify

audit plans and are more likely to increase the extent of their audit tests in response to increased fraud risk as

compared with the pre SAS 82 participants. Moreover, Saksena, (2010; P4) also supported the use of red flags

checklist for fraud detection as her paper included a checklist containing top 25 red flags for fraud and she is

convinced that through the use of a potential fraud signals checklist all auditors would be able to review their clients

for the top 25 fraud schemes and that for auditors to be effective in their efforts they need to learn from their and

other professionals experiences.

This debate about the effectiveness of red flags in fraud detection increased our interest in determining

whether red flags associated with fraudulent financial reporting can really help external auditors in detecting such

fraud scheme in Egypt. The red flags included in this research paper were obtained from SAS No.99 list of red flags

for financial statement fraud and from other academic research in the literature. Thus, the following hypotheses

were derived from the literature:

H1: SAS 99 red flags for fraudulent financial reporting can help auditors in identifying this fraud scheme

H2: Other red flags associated with each type of fraudulent financial reporting can help auditors in

identifying this fraud scheme.

On the other side, some researchers were interested in knowing whether the existence of other factors

affect the perception of external auditors about the ability of red flags to detect fraud such as the research that was

carried out by Moyes, G. and Baker, C. (2009; P.3). In this research, they listed the factors influencing the use of

red flags to detect fraudulent financial reporting. Those factors were possession of an MBA or MA, external auditing

experience, CPA License, prior exposure to red flags, attending conferences on red flags, in house training on red

flags, the employer having previously detected fraud using red flags, the size of the firm, gender, position, and

income of the auditor. Findings showed that CPA firms seem to be significantly more effective in fraud detection

using red flags if their auditors have accumulated more external auditing experience, get graduate degrees,

frequently used red flags in fraud detection, and attended red flags conference.

Another research study by Hackenbrack (1993; P.5) who investigated the effect of auditor experience with

different-sized clients on auditor evaluations of fraudulent financial reporting indicators using two experiments. He

finds that auditors assigned primarily to audits of large companies placed more emphasis on the opportunities to

commit fraud rather than auditors assigned to small companies. Reasons for this difference relate to differences in

control structures between large and small companies and the effect of such differences on auditor perceptions of

the importance of opportunities. One suggestion is that red flag lists need to take into account the effect of client

size on different fraud risk factors.

Moreover,(Hogan et al, (2008, P. 236) cited a research study carried by Knapp and Knapp (2001) where

they examined the effects of audit experience on the effectiveness of analytical procedures in detecting financial

statement fraud and find that audit managers are more effective than audit seniors in assessing the risk of fraud

with analytical procedures. In summary several factors that affect the quality of audits have been found to be

associated with the likelihood of client firms reporting fraudulent financial information. Specifically, these are audit

firm size, the level of auditor industry specialization, the length of auditor tenure, and the experience of the auditor.

Furthermore, Farber (2005; P.6) finds that fraud firms have poor governance relative to no fraud firms(fewer

independent board members, fewer audit committee meetings, fewer financial experts on the audit committee, a

smaller percentage of big 4 auditing firms, and a higher percentage of CEOs who are also chairman of the board.

Thus, in our research study we were also interested to know whether the type of audit office and years of

experience affect external auditors’ ability to identify red flags associated with financial statement fraud. However, a

research carried out by Smith (2005, P.82) found that gender, auditors years of experience and auditors tenure do

not appear to have a significant impact on auditors perception. Neither did the type of audit firms except for the two

red flags, namely, presence of aggressive incentive programs and high vulnerability to interest rates. Auditor

experience of fraud did not appear to have an impact on auditor’s perception except for one red flag which is “high

turnover of senior management”.

As a result of the above debate, we were also interested in exploring whether demographic factors can

affect auditors perception about the ability of red flags to detect financial statement fraud in Egypt. Thus the

following hypotheses were developed:

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H3: There is a relationship between auditors’ experience and their perception about red flags for financial

statement fraud

H4: There is a relationship between type of audit office and their perception about red flags for financial

statement fraud

3. RESEARCH METHODS

A list of most of the possible red flags that can be associated with fraudulent financial reporting was

prepared. These red flags were collected from different sources of literature including SAS No 99 and prior

research studies. This list was then used to build a questionnaire that included questions about the ability of the

listed red flags to detect each type of fraudulent financial reporting. Data collection was conducted in two phases: a

pilot study phase and a questionnaire survey phase. A pilot study was used to pretest the questionnaire and was

be followed up by interviews. The questionnaire was then refined according to the results of the pilot study

performed by more than fifteen audit managers working in one of the leading audit firms with international

affiliations. Then a questionnaire was delivered by hand to a number of external auditors working in audit firms in

Egypt. The sample was selected randomly from domestic listed audit firms with the Egyptian institute of Accountants

in Egypt. Our sample was affected by accessibility to audit offices and external auditors’ years of experience

because the questionnaire included a number of highly technical questions that may require sufficient years of

experience in the audit field. About 100 questionnaires were distributed to external auditors having different years

of experience and working in different audit firms and offices in Egypt but only 93 questionnaires were collected.

The questionnaire included 4 main sections where the aim of each section is to test each hypothesis. The

first section for instance was testing the first hypothesis, the second section was testing the second hypothesis and

the third section was testing the third hypothesis. The questionnaire was about 8 pages including a cover letter

which was addressed to the applicants. The questionnaire included the research purpose, its main objective, and a

request of cooperation from the part of the applicants in completing the practical part of the research. It also

included a statement that ensures the confidentiality in using the responses of the applicants as it will only be for

academic research purpose. All the questions were closed ended questions and the research used the nominal

scale which provide only two alternative answers that each respondent was requested to choose from (Agree or

Disagree). For each variable, a value of “1” was given to respondents who choose “agree” and the value of “0” was

given for the “disagree” option.

4. RESULTS AND DATA ANALYSIS

Data from the collected 93 questionnaires was analyzed using the SPSS. Frequency tables, other

descriptive statistics such as the mean and standard deviation, along with contingency coefficient were used to test

the research hypotheses.

Tables (1) and (2) below show demographic information about the respondents. The respondents in this

study have years of experience ranges from 2 years to more than 10 years and the sample of audit offices were

from international, national, and local audit offices and firms. From table I, it is clear we have only 2 external

auditors from the big 4 international audit firms because we had difficulty in gaining access to those firms. This is

one of the limitations in our study. It is also shown that 75 auditors in our study were from national audit firms with

international affiliations, and 16 auditors from local audit firms in Egypt. Table II however shows auditor years of

experience. We had 31 auditors with less than 2 years and less than 5 years of experience. We also had 13

auditors with less than 10 years of experience and 18 auditors with more than 10 years of experience in the audit

field.

Table 1. Frequency for the number of external auditors in each audit office

Frequency Percent Valid Percent Cumulative Percent

Valid Big 4 2 2.15 2.15 2.15

National 75 80.6 80.6 82.79

Local 16 17.2 17.2 100

Total 93 100 100

Table 2. Frequency for the number of external auditors with different years of experience

Frequency Percent Valid Percent Cumulative Percent

Valid less 2year 31 33.3 33.3 33.3

less 5 years 31 33.3 33.3 66.6

less 10 years 13 13.97 13.9 80.64

more 10 years 18 19.3 19.35 100

Total 93 100 100

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Test of hypotheses;

The first hypothesis predicts that SAS 99 red flags can help external auditors to detect financial statement

fraud. The frequency table 3 and the descriptive statistics table 4 below support this hypothesis where the number

of external auditors who agree on the ability of SAS 99 red flags for financial statement fraud to detect such fraud

scheme was greater than those who disagree The descriptive statistics table 4 also shows that the average of all

means is 86% and this shows a high acceptance rate for SAS 99’s red flags for fraudulent financial reporting.

Frequency table (3) for SAS 99 red flags for fraudulent financial reporting

Ranked SAS 99 Red flags for fraudulent financial reporting External auditors' opinion

Agree Disagree

Formal or informal restrictions on the auditor that limit his access to

people or information or to his communication with the board members &

audit committee. 90 3

Management displaying a significant disregard for regulatory authorities.

89 4

Domination of management by a single person or small group without

compensating controls 89 4

Management changes its accounting policy such as changes in policies

of pricing inventories or in valuating investments in order to manipulate

the company’s financial statements 88 5

Inadequate monitoring of significant controls and Management failure to

correct known reportable conditions on a timely basis.

87 6

Ineffective accounting staff, IT or internal audit staff, and Audit committee

members have little expertise in financial reporting. 85 8

Known history of law violations or claims against the entity or its senior

management alleging fraud 83 10

Failure to record dishonest acts and other disciplinary actions and Lack of

key employee training programs. 83 10

Unusually high dependence on debt. 82 11

Unreasonable time constraints on the auditor regarding the completion of

the audit or the issuance of the auditor’s report 82 11

High turnover of senior management, counsel, board members or key

employees may be an attempt to prevent them from learning too much

about the firm. 82 11

Many accounts are based on significant estimates or are subject to

potential change that may have a financially disruptive effect.

79 14

A failure by management to display and communicate an appropriate

attitude regarding internal control and the financial reporting process.

79 14

Tremendous changes in industry conditions such as decreasing demands

on company’s products, technological changes, fast impairment in

company’s products. 77 16

Tight credit, high interest rates and reduced ability to acquire credit.

77 16

Management ineffectively communicates and supports the entity’s values

or ethics or communicates inappropriate values or ethics.

73 20

Management setting aggressive financial targets and expectations for

operating personnel. 72 21

Difficulties in collection of accounts receivable from classes of customers

who may be experiencing severe economic pressures.

72 21

A large percentage of the organization’s board members are not

independent of the organization. 72 21

Vague organizational structure to the extent that it is difficult to determine

who controls the entity. 70 23

The audit committee members meet infrequently or less than twice

annually. 67 26

Rapid growth or unusual profitability especially compared to that of other

companies in the same industry

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Table: 4. Descriptive statistics for external auditors' opinion on SAS 99 red flags

N Valid 93

Missing 0

Average of all means 0.86

Red flags in Table 3 were also ranked according to their relative importance or likelihood of occurrence

based on external auditors opinion. The most accepted red flags were; “Formal or informal restrictions on the

auditor that limit his access to people or information or to his communication with the board members & audit

committee”, followed by ‘management displaying a significant disregard for regulatory authorities”, and “domination

of management by a single person or small group without compensating controls”. Which are all from the fraud risk

factor group “management influence over the control environment”. While the least important red flags based on

auditor opinion were; “The audit committee members meet infrequently or less than twice annually” and the red

flag; “Rapid growth or unusual profitability especially compared to that of other companies in the same industry”

which belong to the fraud risk group “operating and financial stability characteristics”.

On the other hand, the second hypothesis predicts that other red flags for each type of fraudulent financial

reporting that were obtained from the literature can help external auditor in detecting each type of such fraud

scheme. Results from table “5” below show that the number of external auditors who agree on the red flags

associated with each type of financial statement fraud scheme were greater than those who disagree. The average

of all means is presented in table “6” and shows high acceptance of those red flags based on external auditor

opinion. Red flags listed in table 5 were ranked by importance based on external auditor opinion and the most

important red flag in revenue recognition and timing difference scheme was; “The manipulation of accrued

revenues realized from the company’s investments using incorrect amounts for expected cash dividends

distribution”. while the least important red flag was “An unusual surge in sales by a minority of units within a

company or of sales recorded by corporate headquarters”. In concealed liabilities scheme, the most important red

flag was “ignoring tax liabilities and claims that are due” while the least important red flag was “unusual decline in

the number of days’ purchases in accounts payable”. “Significant related party transactions not in the ordinary

course of business without this fact being disclosed” was the most important red flag in improper disclosure

scheme. In improper asset valuation scheme, however, the most important red flag was “The existence of assets

that are based on significant estimates that involve unusually subjective judgments or uncertainties”. Table “6” also

shows that the highest average means were in red flags associated with improper disclosure and this indicates the

importance of considering these red flags by external auditors when auditing their clients firms.

Table 5. Additional red flags for financial statement fraud

Ranked Red flags for fictitious revenues and timing differences External auditors' opinions

Agree Disagree

The manipulation of accrued revenues realized from the company’s investments using

incorrect amounts for expected cash dividends distribution. 90 3

Not recognizing discounts given to customers. 90 3

Improper recording of sales using accrued revenue account instead of accounts receivable

account & justifying this by claiming that clients didn’t receive sales invoices. 89 4

Recording returned goods after the end of the period 88 5

Large, complex, and unusual transactions close to year end 88 5

Tendency to smooth income or manage earnings by either keeping the books open after the

period to record revenue or prematurely closing the books in order to shift income to the

next period. 87 6

A significant portion of management’s compensation represented by bonuses, stock options,

or other incentives which can be a good reason for management to manipulate revenues in

order to get bonuses. 86 7

Understating allowance for doubtful accounts, thus overstating receivables. 85 8

The company do not record returned goods from customers. 84 9

A significant volume of sales to entities whose substance and ownership is not known. 83 10

The company didn’t write off uncollectible receivables. 81 12

Write off uncollectible receivables in a later period. 80 13

Recognizing revenues too early such as billing customers prior to the delivery of goods.

78 15

rapid growth or unusual profitability especially compared to that of other companies in the

same industry 76 17

Unusual growth in the number of days’ sales in receivables. 75 18

An unusual increase in company’s sales from only the main branch of the company or from

very few branches. 73 20

Loss of a major customer that has created a pressure to replace lost revenues. 70 23

An unusual surge in sales by a minority of units within a company or of sales recorded by

corporate headquarters. 52 41

76 | w w w . i j a r . l i t . a z

Ranked Red flags for concealed liabilities

Ignoring tax liabilities or claims that are due 90 3

No independent checks on bank reconciliations and payments 86 7

Improper or lack of recording sales returns and allowances 85 5

The existence of allowances for sales returns, warranty claims that are shrinking in

percentage terms or are otherwise out of line with industry peers. 82 11

Reducing accounts payable while competitors are stretching out payments to vendors

78 15

The existence of expenses that are based on significant estimates that involve unusually

subjective judgments or uncertainties. 76 17

Unusual decline in the number of days’ purchases in accounts payable 60 33

Ranked Red flags for improper disclosure

Significant related party transactions not in the ordinary course of business without this fact

being disclosed. 92 1

Known history of violations of securities laws or other laws and regulations or claims against

the entity, its senior management, or board members alleging fraud or violations of laws and

regulations without this fact being disclosed. 92 1

Not disclosing the company’s real disputes with banks relating to long term loans and its

interests. 89 4

Inadequate disclosure for the company’s financial investments. 88 5

Recurring negative cash flows from operations or an inability to generate cash flows from

operations while reporting earnings and earnings growth. 89 4

Ranked Red flags for improper asset valuation

The existence of assets that are based on significant estimates that involve unusually

subjective judgments or uncertainties. 92 1

Non financial management’s excessive participation in the selection of accounting principles

or the determination of significant estimates. 91 2

Unusual change in the relationship between fixed assets and the related depreciation

expenses. 86 7

The company’s management shows an increase in its long term investment in assets while

its competitors are decreasing such investments. 85 8

Inadequate separation of duties among the functions of recording assets on books, keeping

those assets, and authorization of these assets inside the company. 85 8

Significant inventories or assets that require special expertise for valuation 75 18

Recording fictitious values in the inventory account with no corresponding payables &

liabilities to vendors. 91 2

Reconciling deficits in inventory by recording some inventories which are in good state as

scrap or spoiled inventories. 91 2

Excessive or large adjustment after a physical inventory count 91 2

Unexplained fluctuations in any inventory account 89 4

Significant, unexpected, or unexplained increases in cost of goods sold. 89 4

Physically moving inventory during test counts which may cause a fictitious increase in

inventory. 89 4

Misapplying lower of cost or market test 88 5

False confirmations of offset inventory held by others. 88 5

Close to physical count period, the store keeper prepares inventory disbursement

documents & records them in the books without actually sending them to customers except

at the beginning of the following year. 86 7

Placing empty boxes with full boxes of inventory to deceive those performing the inventory

physical count. 85 8

Close to physical count period, an employee receives goods purchased and delays its

recording in daily journal entries. 85 8

Overstating inventory by including inventory in transit. 75 18

The existence of a large amount of obsolete or slow moving inventory. 69 24

Table 6. Average of all Means

Red Flags N Valid Missing Average means

Fictitious revenues and timing differences 93 93 0 0.87

Concealed liabilities 93 93 0 0.86

Improper disclosure 93 93 0 0.97

Improper assets valuation 93 93 0 0.92

B a k u , A z e r b a i j a n | 77

The third hypothesis however predicts that there is a relationship between external auditors’ years of

experience and their ability to identify red flags for fraudulent financial reporting. Contingency coefficient was used

to get the relationship between these two qualitative variables. The P-value for each red flag ranges from “0.1 to 1”

thus, they were all greater than 0.05. This means that there is no significant difference among the opinions of

external auditors having different years of experience about the ability of red flags to detect fraudulent financial

reporting. This can be justified by the fact that other factors can be more important than experience in affecting

external auditors’ ability to detect financial statement fraud such as direct knowledge about red flags for fraud

through acquiring professional certificates in fraud detection or attending international conference about fraud.

As for the fourth hypothesis which predicts that there is a relationship between the type of audit office and

external auditors’ ability to identify red flags for fraudulent financial reporting, the P-value for each red flag was

greater than 0.05 except for two red flags where P-value was less than 0.05. the first red flag is; “Unusual surge in

sales by a minority of units within a company or of sales recorded by corporate headquarters” (P-value 0.004). this

red flag is related to “revenue recognition and timing difference scheme”. The second red flag is “management

ineffectively communicates and supports the entity’s values or ethics or communicates inappropriate values or

ethics” (P-value 0.008). this red flag is related to SAS No.99 fraud risk factor group “Management influence over

the control environment”.

To sum up the research findings, our research supported the use of red flags as a tool for detecting

fraudulent financial reporting. This was consistent with the research carried out by (Glover et al, 2003, P4),

(Saksena, 2010, p.4), (Bossard and Blum, 2004, p.2), (Silverstone and Michael, 2007, p.61), and (Wells, 2005,

p.89). our research also supported the importance of ranking red flags according to their relative importance. This

was consistent with the research conducted by (Vicky et al, 1996, p.5) and (Smith, 2005, p.82). However we had

different ranks from that included in Smith research as he found that the SAS 99 fraud risk factors in the “operating

and financial stability characteristics group” were the most important risk factors based on external auditor opinion.

While our research findings showed that risk factors in the “management influence over the control environment

group” were the most important red flags for fraudulent financial reporting. Moreover our research found that lack of

proper disclosure about related party transactions is the most important red flag in improper disclosure fraud

scheme and this is consistent with Hogan et al (2008; P. 244 as cited by Gordon et al; 2007) who stated that

related party transactions is one of the top reasons cited for audit failure when a fraud does occur. The effect of

demographic factors on auditor perception about red flag for fraud was not supported in our research and this was

consistent with Smith research (2005, p.82) where type of auditor years of experience was insignificant and so was

type of audit office except for two red flags. However the two red flags that were found significant in our research

are different from those found by Smith.

5. CONCLUSION

This research study determines whether red flags for fraudulent financial reporting listed in SAS 99 and in

other literature can help external auditors in detecting such fraud scheme. The research also determines whether

external auditors experience and the type of audit office affect external auditors’ ability to identify red flags for

fraudulent financial reporting. This study provides several practical implications that are informative about the

quality of red flags to be considered by external auditors and about fraud detection in general. First, results from

our questionnaire suggest that SAS 99 red flags and the other red flags for each type of fraudulent financial

reporting can be helpful for external auditors. SAS 99 provided a list of red flags related to each fraud factor like

incentives, opportunities, and rationalization, but these red flags were too general and aren’t specifically related to

any of the types of fraudulent financial reporting. Our research included a list of specific red flags that can be most

likely associated with each type of fraudulent financial reporting and those red flags were highly accepted by the

sample of external auditors in our study. These specific red flags can be used in conjunction with SAS 99 red flags

to enhance external auditors’ ability in detecting fraudulent financial reporting.

Second, the research also ranked all red flags for fraudulent financial reporting according to their relative

importance based on external auditor opinion. Highlighting the red flags that can be most likely to occur will help

auditors to focus their efforts more on high quality red flags during brainstorming sessions which will in turn

facilitate fraud detection. Third, our research didn’t support the effect of demographic factors on external auditors

perception about red flag for fraudulent financial reporting which indicates that educating external auditors about

red flags will enhance their ability to detect fraud regardless of how different is their demographic factors. However,

this study is subject to several limitations. First, we were not able to get more than two external auditors from the

big 4 international audit firms to fill in the questionnaire and thus our results can’t be generalized to all audit firms in

Egypt. Second we tried to list every possible red flag for fraudulent financial reporting but certainly there can be

other red flags in the literature that aren’t mentioned in the research study. Thus future research should be more

directed toward listing other red flags for fraudulent financial reporting in the literature and should test them using

other methods like experiments or interviews.

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