Six Red Flags of Financial Statement Fraud

Many incidents of fraud are discovered inadvertently. For example, a staff member may notice something that doesn’t seem right and mentions it to a manager. Upon investigation, internal theft is found. But considering the potential damage that fraud can inflict on a company, it is obviously better to do more than depend on mere chance.

Keep in mind that the earlier a company detects fraudulent activity, the less damage will be done. With that in mind, here are six red flags that can suggest wrongdoing in your workplace:

1. Unfair practice charges. If your company is sued and the lawsuit involves allegations of unfair business practices, treat the charges as an indication that there may be fraudulent activity.

2. Sudden lifestyle changes. If a staff member buys a larger home, enrolls children in private schools, or starts taking numerous overseas vacations, consider further investigation.

3. Management behavior. Manager’s actions should be monitored closely to determine if they are acting ethically. Do they have a reputation for succeeding at all costs? If management fails to lead by example, lower level employees may decide that they can also pursue unethical behavior.

4. SOX Section 404 non-compliance. If your company is public and has been notified that it isn’t complying with Section 404 of the Sarbanes-Oxley Act, start looking into weaknesses in your company’s internal controls — with fraud in mind.

Section 404 requires a company to include in its annual report a management report on the company’s internal controls over financial reporting. Notification of non-compliance not only means your controls need strengthening, it can be a sign that fraud is being committed.

5. Outperforming peers. Start asking probing questions if your company’s performance far surpasses that of others in the industry — particularly if your company’s sector recently experienced a difficult operating environment.

6. Past performance. You’ve likely seen the investing disclaimer that “past performance may not be indicative of future performance.” Within the world of fraud detection, past performance can actually serve as an indicator of future criminal activity.

An ethical climate does not materialize overnight at a company. Depending on the size of previous frauds and whether or not all of the perpetrators were discovered and fired, your business could still be susceptible to new fraudulent acts.

Fraud detection and prevention is a highly specialized area of accounting. However, with the assistance of an attorney, certain clues can help a company proactively investigate fraudulent activity before it becomes a media event.