Corporate Structure and Identification of Red Flags

Preamble

When we look at the corporate structure, hierarchy, authority policy, or limits assigned to various transactions, we have systems to monitor them. Many a time, the structure and routing of transactions are so auto-piloted that the chances of the occurrence of fraudulent transactions are made possible by more than three people coming together. A simple example of this is the limits given to purchase orders or payments; this can be easily broken down into two or more than two, and transactions are authorized. Another example is goods received, where stores, security personnel, and the purchase team join hands. In most cases, there is a lot of transactional fraud that happens in repairs to buildings as well as in the sale of scrap. Sometimes we see "abuse of position, or "false representation," or "prejudicing someone's rights for personal gain."  These are nothing but fraud. In simple terms, it is an act of deception intended for personal gain or to cause a loss to another party.

Before understanding Red Flag, we need to see why such things happen. As per the recent study by Assocham and Grant Thorton, the most vulnerable sectors are:

• Real estate and infrastructure: 52%
• Financial Services: 34%
• Telecom 5%
• Manufacturing 3%
• Electronics and IT/ITES: 2%
• Hospitality and Tourism: 2%

Donald Cressey, a sociologist and criminologist in the 1940s, was one of the first to specialize in the field of understanding fraudsters and why they do what they do. Normally, there are three behaviors that lead to such action.

1. Perceived Pressure
2. Perceived Opportunity
3. Rationalization

Wolf and Hermanson (2004) introduced the fraud diamond model, where they presented the view that the fourth variable is "capability," as they believed that without the capability to do so, fraud would never happen.

Steve Albrecht gave another theory that situational pressure, perceived opportunities, and personal integrity are three factors that affect such transactions. When personal integrity is high and the other two factors are low, occupational fraud is less likely, and vice versa.

Red Flags

It is a sign or warning of any impeding danger or inappropriate behavior. Red flags do not necessarily indicate the existence of fraud; however, they are indicators that caution needs to be exercised while investigating the situation. It is divided into three parts:

• Financial performance Red Flags
• Accounting System: Red Flags
• Operational red flags
• Behavioural Red Flags
• Structural red flags
• Personnel Red Flags

Financial Red Flags

Financial red flags include aggressive goals and performance measures both at the company and individual level.

Companies whose financial performance suggests the possibility of fraud might include some of these signs:

1. Persistent cash flow problems even when the company has regularly reported profits
2. A pattern of similar audit adjustments is proposed year after year.
3. Unusual financial ratios when compared to competitors
4. Outstanding results when the rest of the industry has suffered a downturn
5. Significantly outpacing competitors in the industry.

Accounting System: Red Flags

A good, secure accounting system cannot exist without internal controls, and the company cannot be free from error and fraud without such controls. Some of the basic red flags that might be noted in a company's accounting records include:

1. Unusual timing of the transaction. This includes the time of the day, the day of the week, or the season.
2. Frequency of transactions
3. Unusual amount recorded
4. There are questionable parties involved.

Operational red flags

They indicate how a company does business each day. Do things run smoothly, minimizing the chance for errors and problems?

Is it that things are managed in such a fashion that errors go unchecked and employees do whatever they want whenever they want?

Behavioural Red Flags

In one of the reports from ACFE, they found out that 44% of the fraud perpetrators were living beyond their means while the fraud was ongoing, and 33% were experiencing known financial difficulties. 22% of common red flags were close associations with the vendor or customers, 21% displayed control issues or unwillingness to share duties, 18% had a general "wheeler dealer" attitude", and 17% were on account of divorce or family problems.

Structural red flags

In this case, employees become familiar with operations, and they begin to understand what accounts are not getting monitored, which areas of the company are poorly supervised, and what size of transactions create added scrutiny. They take advantage of the structure, policies, and procedures that are in place.

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.

There are a few indicators that need to be monitored for all types of flags, either red or yellow (unusual nature) or green (too good to be true).

1. Sudden Losses
2. Management overrides internal controls.
3. Excessive credit notes
4. Excessive debit notes
5. Excess purchases and payment pressures
6. TGTBT Syndrome (Too Good to Be True)
7. Orphan funds in the organization, i.e., unaccountable funds
8. Missing Documentation
9. Chaotic conditions
10. Behavioral issues like:
    1. Failure to take vacations
    2. Insider informer/trading
    3. Living beyond one's means
    4. Early arrival, late departure
    5. Irrational behaviour
11. Complains, surges, or falls.

Conclusion 

It is always better to have a check and balance on the transactions when the company is growing. It is not possible to check each and every transaction, but the same can be managed through scientific sampling, questionnaires, interviews of the existing employees at random for the check and balances, mapping of behavior with the transactions, etc. In an organized company, there are more chances of getting such flags or indicators that need to be plugged. Whistleblowers should be encouraged for the same, and the present systems are to be checked with one full transaction to see the possibility of fraud.

Disclaimer: Although due care is taken, it is prepared for general knowledge purposes and not for specific use. The readers are advised to take proper note of the same and to take specific advice before acting on the same. One should not act upon the information contained in this article without obtaining expert and professional advice. Further, no representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this article.

Bibilography: Various Sites on Forensic Accounting, ICAI Material on Forensic Accounting.