Assurance and Forensic Accounting

Topic 4 – Detection and Analysis of Fraud Symptoms

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Topic 4 – Detection and Analysis of Fraud Symptoms i

Contents

Contents ii

Introduction 1
Learning objectives 1

The nature of kickback: Red Flags 2

Financial statement and ratio analysis 3

Summary 4

References 5

ii Assurance and Forensic Accounting

Introduction
Auditors have analysed data to detect fraud and anomalies for many decades. In
particular, the personal computer – particularly with spread sheet programs and
database management systems. Accounting anomalies are primarily caused by control
weaknesses. They are not intentional mistakes; they are simply problems in the
system caused by failures in systems, procedures, or policies. Sampling is an
effective method for discovering routine anomalies that occur throughout an audit
period, but it is often ineffective for fraud detection. In this topic we identify how
basic fraud analysis techniques including digital analysis, discovery of outliers,
stratification and summarization, time trending, and fuzzy matching.

Learning objectives
At the end of this topic you should be able to:
 illustrate how to conduct financial statement and ratio analysis
 Convey the nature of kickbacks and red flags that help identify these.

Recommended Text
Fraud Examination, 6th edition, Albrecht et al., (2019). Chapter 6.

Data-driven fraud detection [Excerpt] pp. 195-205

Web resource
All Auditing and Assurance Standards are available from:
http://www.auasb.gov.au/

Topic 4 – Detection and Analysis of Fraud Symptoms iii

The nature of kickback: Red Flags
Fraud detection can to undertaken under a proactive method. Questions to be
asked include: What types of fraud could be committed against the company
or on behalf of the company? How could employees or management acting
alone commit fraud? How could vendors or customers acting alone commit
fraud? And how could vendors or customers working in collusion with
employees commit fraud?

Red flags of kickbacks include:

 Analytical symptoms i.e.
- Increasing prices
- Larger order quantities
- Increasing purchases from favoured vendor
- Decreasing purchases from other vendors
- Decreasing quality.
 Behavioural symptoms i.e.
- Buyer doesn’t relate well to other buyers and vendors
- Buyer’s work habits change unexpectedly.
 Lifestyle symptoms i.e.
- Buyer lives beyond known salary
- Buyer purchases more expensive automobile
- Buyer builds more expensive home
- How do you find out this information.
 Control symptoms i.e.
- All transactions with one buyer and one vendor
- Use of unapproved vendors.
 Document symptoms i.e.
- Invoices from vendor to buyer’s relative.

Financial statement and ratio analysis

Horizontal and vertical financial statement analysis using different financial
ratios can detect problems and anomalies in financial data. Approaches to
Financial Statement Analysis:
iv Assurance and Forensic Accounting
  comparing account balances from one period to the next using
vertical and horizontal analysis
 calculating key ratios and comparing them from period to
period
 performing vertical analysis
 performing horizontal analysis.
But before this is done, need to understand the ‘chart of accounts’ and ‘the
operating cycle’ of the firm.

Financial ratios are used in practice to analyze the financial performance

and stability of firms. A ratio is a mathematical form whereby a numerical
variable is expressed relative to a base. That is, expresses the relationship
between the numerator and denominator. This can be used in a commercial
sense to obtain an understanding of how efficient are management in
managing the firm’s profit and capital. This can be used in forensic
accounting to gain primarily a sense about the existence of anomalies in the
financial statements. For example net profit (numerator) can be expressed
as a percentage of total sales (base/denominator).
Ratios can also be expressed as decimals, for example, the working capital
ratio is for the firm is .7, and also as ‘rates’, for example the stock
turnover rate for the firm is six times per year. Ratios can further be
expressed in a time period, for example the debtors turnover which can be
expressed as the number of days it takes to collect debts from customers.

What you are interested in identifying:

 why does the ratio change, not merely the fact that it has
changed! and
 does the ratio change in accordance with expectations, if not,
why not.

Use with caution because ratios can be manipulated by fraudulent or

‘incorrect’ financial statements. Ratios reflect policy interactions:
 numerator driven policies: what drives cost of goods sold?
 denominator driven polices : what drives sales?
 under what circumstances is numerator or denominator easier
or exposed to manipulation?

Aim is to have a low cost of goods sold ratio (i.e. expense), therefore in this
case, incentive is to do things that lower numerator or increase the
denominator. Which one or both?
Ratios do not provide all the answers. Ratios are indicators that generate
inquiry. Interpretation of ratio data provides an understanding of not just
the profitability and financial stability of the firm but also unexplained
changes which can be indicative of fraud. Strict Proportionality Assumption
is based on implicit assumption of strict proportionality between numerator
and denominator, i.e. a linear relationship. The assumption is not always
Topic 4 – Detection and Analysis of Fraud Symptoms v
 valid because the existence of conditions which may negate strict
proportionality.
Careful that you do not jump to incorrect conclusions, for example:
 Unusual behavior could be explained by economic or business
conditions
 Existence of fixed costs can imply a negative constant term.
 An income source that is non-variable and not related to sales,
can imply a positive constant term.
 Economies of scale can create nonlinear relationship between
say, earnings and sales.

Summary
Analysis of published financial statements is second best evidence as
management accounts are not published for general circulation. However,
these can be demanded by the firms lenders and suppliers as part of due
diligence. Examples of financial statement fraud are abound. Some of these
frauds were missed by normal auditing techniques, but they could have
been detected using horizontal or vertical analysis. In some cases, the
unexplained changes were obvious; in other cases they are subtle.
Unfortunately, managers and auditors have often used ratios, horizontal
analysis, and vertical analysis only as tools for assessing an organization’s
performance. In sum, auditors should incorporate these types of analyses;
when doing so highlights unusual balances in the financial statements, and
then they must also follow up with a diligent search for answers by
competent and sceptical personnel. The next topic further investigates the
use of ratio analysis in fraud detection, introducing students to the Beneish
Ratios.

References

Albrecht et al., (2019), Fraud Examination, 6th edition, Cengage.

vi Assurance and Forensic Accounting