SESSION II

RED FLAGS
 WHAT IS RED FLAG?

Red Flags are sign or warning of

any impending danger or
inappropriate behaviour. Red Flags
do not necessarily indicate the
existence of fraud however are A normal accountant act like the
indicators that caution needs to be policeman the forensic investigator role is
exercised while investigating the akin to the CID/CBI and looks for signs
situations. which indicate abnormal and unusual
behaviour. Such signs are referred to in
forensic accounting parlance as red flags.
 TYPES OF RED FLAGS
Financial
performance red
flags They include aggressive goals and performance measures.

Accounting They refer to the organization of the accounting system and

system red flags the level of internal controls that are in place.
Operational red
flags They highlight how a company does business each day.
Behavioural red
flags They include behavioural patterns of the employees.

Structural red flags They relate to the way that a company is set up and the
policies and procedures that are in place.

Personnel red flags They refer to the employment policies and procedures within a
company
FINANCIAL PERFORMANCE RED FLAGS

When a certain level of • Significantly outpacing

performance is competitors in the industry
mandated, by the boss, • Outstanding results when the rest
Investors, the bank, or of the industry has suffered a
otherwise, there can be a downturn
• Unusual financial ratios when
temptation to turn to
compared to competitors
fraud to meet these • Persistent cash flow problems,
goals. Companies whose even when the company has
financial performance regularly reported profits
suggests the possibility • A pattern of similar audit
of fraud might include adjustments proposed year after
some of these signs: year
 ACCOUNTING SYSTEM RED FLAGS
They refer to the Unusual timing of the transaction. This includes the time of day, the day of the week,
organization of the or the season.
accounting system
and the level of
internal controls that
are in place. A good, Frequency of transactions. Transactions that are occurring too frequently or not
secure accounting frequently enough are suspicious. Each company has its own operating patterns, and
system cannot exist the transactions should be booked accordingly.
without internal
controls, and the Unusual amounts recorded. Take notice of whether an account has many large, round
company cannot be numbers entered. Consider whether some of the transactions in the account are far
free from error and too large or far too small.
fraud without such
controls. Some of the
Unusual amounts recorded. Take notice of whether an account has many large, round
basic red flags that
might be noted in a numbers entered. Consider whether some of the transactions in the account are far
company’s too large or far too small.
accounting records
include: Questionable parties involved. Payment being made to a related party? Is the
company paying large sums to a vendor whose name is not easily recognizable or is
not a normal vendor of the company
 OPERATIONAL RED FLAGS

They highlight how a company does business each

day. Do things run smoothly, minimizing the
chance for errors and problems? Or are things
managed in such a fashion that errors go
unchecked and employees do whatever they want,
whenever they want?
 BEHAVIOURAL RED FLAGS
They include behavioural patterns of the employees.

• In “Report to the nations on occupational Fraud and Abuse’ by ACFE

identified the behavioural indicators displayed by Fraud Perpetrators. The
below figure shows the distribution of those red flags. Approximately 44% of
fraud perpetrators were living beyond their means while the fraud was
ongoing, and 33% were experiencing known financial difficulties. Other
common red flags were an unusually close association with a vendor or
customer (22%), displaying control issues or an unwillingness to share duties
(21%), a general “wheeler-dealer” attitude involving shrewd or unscrupulous
behaviour (18%), and recent divorce or family problems (17%). These six red
flags were also the most common behavioural indicators in each of ACFE’s
last three studies.
STRUCTURAL RED FLAGS

They relate to the way that a company is

set up and the policies and procedures
that are in place. Those very systems
create opportunities for fraud each day.
Employees become familiar with
operations, and they begin to understand
what accounts are unmonitored, which
areas of the company are poorly
supervised, and what size of transaction
that creates added scrutiny.
 PERSONNEL RED FLAGS

• They refer to the employment policies and procedures within

a company, including hiring procedures, advancement
policies, employee monitoring programs, and disciplinary
standards.
APPENDIX 3 OF SA 240

THE AUDITOR’S RESPONSIBILITIES

RELATING TO FRAUD IN AN AUDIT OF
FINANCIAL STATEMENTS’ contains examples of
certain Red Flags i.e. examples of circumstances that
may indicate the possibility that the financial
statements may contain a material misstatement
resulting from fraud.
 INDICATIONS OF MATERIAL MISSTATEMENT
RESULTING FROM FRAUD
• Unsupported or unauthorized balances or transactions
Discrepancies in the • Last-minute adjustments that significantly affect financial results
accounting records
• Tips or complaints to the auditor about alleged fraud.

• Missing documents
Conflicting or missing • Documents that appear to have been altered
evidence • Unusual discrepancies between the entity's records and confirmation replies
• Significant unexplained items on reconciliations

• Undue time pressures imposed by management to resolve complex or contentious

Problematic or unusual issues
relationships between the • Unusual delays by the entity in providing requested information
auditor and management • An unwillingness to address identified deficiencies in internal control on a timely
basis.
• Accounting policies that appear to be at variance with industry norms
• Tolerance of violations of the entity’s code of conduct.
Others
• Frequent changes in accounting estimates that do not appear to result from
changed circumstances
 INDICIA OF FRAUD

Red flags that are

“Indicia of Fraud” are • Lack of Corporate Governance.
nothing but symptoms • Questionable Accounting Activities
or indicators of • Sudden Losses
situations of frauds. • TGTBT syndrome.
They do not • Generation of ‘orphan’ funds
necessarily indicate
the existence of fraud
• Disaster situations
and hence the auditor • Missing Documentation
should exercise • Chaotic conditions
caution in forming an • Behavioral Issues
opinion before • Complaints
investigating.
LACK OF CORPORATE GOVERNANCE
Close nexus with
vendors, clients, or
external parties -
Absence of rotation of lack of Internal There would be a
duties or prolonged Controls or casual conflict of interests if
exposure in the same approach to reported an employee,
area internal control lapses particularly at a senior
level, were to have
close relations with a
client.

frequent or unusual
no written policies Related Party
and/or procedures transactions ( not
arm’s length)
Questionable Accounting Activities

Management override of
Internal Controls

unreconciled subsidiary &

General Ledger accounts

continuous adjustments of book

to physical inventories

topside Journal Entries

Excessive number of manual

checks
SUDDEN LOSSES.

A company doing quite well

suddenly makes huge losses. While
there could be genuine reasons,
mismanagement of funds and
resources are more likely. These
losses are likely to have been there
all along simmering under window
dressed accounts.
TGTBT SYNDROME

TGTBT stands for Too

Good To Be True. This
indicates that lovely
glossy report may be
furnished whereas in real
terms there are gloomy
conditions.
Disaster situations

Accidents where books have been

lost, or damaged, or
catastrophes such as fire,
earthquake, floods etc. are other
places where fraudsters can feast.
Generation of ‘orphan’ funds

Funds which are held in a fiduciary capacity and for which

there is no accountability are thriving places for frauds. Funds
collected by trusts or donations in cash collection boxes are
typical examples where there is no accountability on either
side. Neither does the donor concern himself about the usage
of the funds nor does the beneficiary have a direct claim or
even awareness in respect of such funds. However such funds
can Familiarization with Red Flags in Detection of Frauds.
 MISSING DOCUMENTATION

This is the surest sign of fraud and practically every

situation of missing records either has been created to
suppress a fraud or if such a situation happens to emerge
it is used to engineer a fraud.
Chaotic conditions

As a corollary of disaster situations, conditions where

accounts are in arrears, messy state or unreconciled, by
and large are artificially created. The reason given
normally is shortage of staff or resources, but this is
more of an excuse.
 Complaints

Frequently tips or complaints will be

received which indicate that a fraudulent
action is going on. Complaints have been
known to be some of the best sources of
fraud and should be taken seriously.
Although all too often, the motives of the
complainant may be suspect, the allegations
usually have merit that warrant further
investigation.
 BEHAVIOURAL ISSUES

failure to take vacations

living beyond one’s means

Insider trading

early arrival – late departure

Irrational behavior
 YELLOW FLAGS
• Unusually high transactional
amounts on a debit credit card
transaction
These are indications of authorized • Login to a system or application
activities which are flagged because
of their unusual nature. These may be from an unusual IP or Location
perfectly legitimate activities which
are worth checking as they may also
be indications of fraudulent activity.
Examples of such activities are
Such transactions are used to enforce preventive measures or
exception reporting e.g. Banks now call up the card holder to
verify if high volume transactions or transactions from a
different location or a foreign location are genuine before
authorization
 GREEN FLAGS

Green Flags are in many ways the converse of Red Flags. They are a
part of the TGBT syndrome referred to earlier. (TOO GOOD TO BE
TRUE). Examples include
• Unusually high returns provided by an investment
• High Profit Margins for a company which are way above the industry average
• Specific companies performing very well when the industry is in a slump

Like Red Flags these are only indicators and are not conclusive
evidence of fraudulent activity and need to be investigated before
reaching a conclusion.
THANK YOU