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Why red flags that suggest material fraud are so hard to spot

Author: ICAEW Insights

Published: 13 Jan 2023

Fraud can be somewhat of a grey area, but there are situations that auditors should scrutinise in particular.

Fraud is a complex issue. Misinterpretations are commonplace in terms of both what counts as fraud and at what point auditors can be expected to spot it. As ICAEW’s recent report on fraud and audit highlights, transgressions are not always obvious and the line between error and fraud can be blurred. Still, there are red flags that may indicate material fraud in financial accounts, albeit they are often hard to spot.

Richard Abbey, EY UK&I Leader, Forensic & Integrity Services, says: “It’s difficult to think about fraud in terms of easy-to-spot red flags: if there were clear red flags, more frauds would be caught. Different sorts of businesses are vulnerable to different types of fraud at different times, and those looking to combat fraud and financial crime need to be prepared to do some digging. There isn’t always one giveaway, and normally a combination of factors needs to be looked at.”

With this in mind, there are a number of contexts that may require deeper investigation. One such is management earn-outs, where a contractual provision exists allowing the seller of a business to secure future compensation if the business achieves certain financial goals. Highly leveraged businesses at risk of breaching covenants could be another.

“Different situations create different incentives for fraud,” says Abbey. “A recently acquired business with a management earn-out may be more likely to overstate earnings, for example. Earnings might also be at higher risk of overstatement where a heavily indebted business is close to breaching borrowing covenants such as debt to earnings ratios.”

An overassertive senior executive or manager who fails to provide verifiable explanations to scrutiny may also foster circumstances that require further digging.

“Broadly though, there are some themes that often – but not always – come up in frauds. Risk radars should be sensitive where businesses have dominant leaders or owner-managers that are reluctant to share information or provide explanations,” Abbey says.

Genuine financial success will be reflected across a balance sheet, so reviewing whether unexpectedly good performance in one area is connected to other parts of a business is good practice, too.

“Adages hold true, as well,” cautions Abbey. “If something’s too good to be true, it might just be. It’s important for a business to look at what underlies its success and to really understand its own business model and what is driving returns and profitability. Successful businesses tend to have cash and tangible assets, so their absence could prompt questions.”

Abbey says internal audit teams should benchmark against their competitors to ensure they understand why trends in the sector are not appearing in their own business or why they are outperforming their competitors.

Management culture can also sometimes be an indicator of potential for fraud. Systems and controls are essential, but fast-growing businesses, for example, often outpace their own internal systems. Abbey cautions against overreliance on controls.

“While businesses may have appropriate controls in place, almost all frauds occur where collusion, management override or IT access has rendered the controls ineffective. Culture and tone from the top are key to making controls work, and management over-reliance on the mere existence of controls is something to watch out for. Even controls need to be monitored to make sure they’re working,” he says.

It’s vital for auditors, internal auditors and management to be aware of the tricks that fraudsters use in order to detect fraud and prevent fraudulent activities. “Frauds are designed to avoid detection and are often complex or occur with management collusion,” says Abbey. “Those responsible for detecting fraud sometimes need to be as inventive as the fraudster to spot them.”

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