How to spot red flags of possible fraud in your finance department

Fraud in the finance function may take a variety of forms — financial statement fraud, misappropriation of assets, illegal acts, bribes, or violation of laws or regulations. There are many warning signs or red flags that indicate a pattern of fraud, and often these items are most visible to the finance department.

There are three elements that are needed when a fraud is committed: Motivation, rationalization and opportunity, says Richard Snyder, a director in Audit & Accounting at Kreischer Miller.

“Motivation and rationalization are driven by an individual or individuals, but opportunity is often created by the company. In many instances, stakeholders and executive management teams place a high deal of trust with individuals based on past experience, long-time working relationships and reputation,” Snyder says.

“An overreliance on certain key financial people, with reduced internal controls and oversight in place, may create the opportunity for fraud.”

Smart Business spoke with Snyder about signs that may indicate fraud is occurring.

What are the costs of fraud in an organization?

There are very real costs which impact organizations when fraud occurs, including:

  • Financial loss, hardship or bankruptcy.
  • Misstatement of financial statements.
  • Distrust of the organization by employees, customers and vendors.
  • Lost or reduced future sales.
  • Damage to an organization’s reputation and/or brand.
  • Damage to key relationships with service providers — bankers, insurance brokers and accountants.

There also are many indirect costs such as legal fees, audit costs, fines or penalties, and the lost time of executives and employees created by dealing with a crisis brought about by the fraud.

What are some of the red flags or warning signs that fraud is occurring?

According to a survey by the Association of Certified Fraud Examiners, the average length of time a fraud occurs is 18 months. Misappropriation of assets accounted for a majority of the frauds that occurred but were the least costly, while financial statement frauds were less common but caused the greatest amount of loss to an organization. There are many warning signs/red flags, including:

  • Significant and subjective judgment in estimates.
  • Earnings pressures related to banking covenants, bonuses or profit levels.
  • Unexpected areas of profitability.
  • Recurring negative cash flows during periods of earnings growth.
  • Revenue reported after period cutoffs.
  • Abnormal selection of accounting policies by management.
  • Omissions or inaccuracies in financial data.

Many times, the finance function will observe these warning signs before other individuals/departments within an organization due to their access to financial information. If the individual committing the fraud is a member of the finance team, however, the fraud may be more difficult to uncover.

How can organizations do a better job of preventing fraud?

Fraud prevention begins with a ‘tone from the top,’ starting with owners and stakeholders, the board of directors and the executive team. Their actions speak volumes to an organization’s employees that fraud will not be tolerated.

Continued oversight of financial results and follow-up on unexpected variances is vital. Establishing conflict of interest, code of conduct and whistleblower policies should be a priority if not currently in place and should be distributed to all employees.

Organizations should complete a periodic fraud risk assessment to identify areas of susceptibility and look at potential red flags and fraud indicators. Many organizations do not discuss fraud, but an open dialogue between management and employees is an excellent way to reinforce individual responsibilities, identify areas of fraud risk and brainstorm ways to improve the organization’s internal control.

A proactive approach to addressing fraud prevention may ultimately help an organization save time, money and embarrassment in the future.

Insights Accounting & Consulting is brought to you by Kreischer Miller