Financial fraud red flags: Searching for the funnel clouds

Fraud examiners, when looking backwards to the early stages of an investigation, report common patterns. Like tornado watches, these signals don't indicate the funnel clouds were sighted but that they might develop because of optimal conditions.  

In 2003, the firm, webMethods, was named the No. 1 fastest-growing software company in North America.

But slowing earnings cratered the stock price from $11 to $4 per share in mid-2004. In November of 2004, an employee of the company's Japanese subsidiary notified webMethods' management that he was concerned about certain transactions. The company swiftly acted. The audit committee investigated and found that the improper activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the company's management, which caused the Japanese subsidiary to engage in undisclosed and unauthorized borrowings. The committee also found that the subsidiary failed to record expenses, recorded improper expenses, and created false documents to support those bogus transactions. Based on the findings of the investigation, webMethods announced that it will restate its financials for most of 2004 and 2005, according to the firm's public statements.

Certainly no one expects that the management of every fast-growing company will commit financial statement fraud. But along with a handful of other red flags, slowing growth is one of the starter conditions for fraudulent actions. Fraud examiners, when looking backwards to the early stages of investigations, report common patterns. Like tornado watches, these signals don't indicate the funnel clouds were sighted but that they might develop because of optimal conditions.

Slowing growth
Of course, the desire to please Wall Street is a strong motivation for managers to commit financial statement fraud. When investors pump prices expecting perennial high growth they alternatively punish stocks that disappoint. For some fraud professionals, fast growers hitting a slow patch top the list for conditions being right for fraud. "Slowing revenue numbers can be a big red flag," says Ronald Hagenbaugh, CFE, CPA, internal audit controls engagement manager at Jefferson Wells in Charlotte, N.C. "Managers start to worry about their own bonuses going down as well as their stock if they get rejected as Wall Street darlings," says Hagenbaugh.

Not that all slowing companies will commit fraud even though the motivation is there. Kelly Bossard, CFE, CPA, manager at FTI Ten Eyck in King of Prussia, Penn., performed much of the SOX-required documentation for a rapidly growing young company. "They had lots of control deficiencies but we worked with them for two months and didn't see any of the typical fraud indicators," says Bossard.

Another motivation might be found in management's desire to meet analysts' quarterly estimates. While not every company slows from speedy growth, all public companies are under pressure to perform to the projected amount per share. "Over a couple of years everybody misses a quarter or two," says Bossard. "If a company is making numbers quarter after quarter you have to be suspicious. Nobody's that good."

In addition to breezing through earnings statements and analysts' estimates, public financial statements yield other clues. Companies that are outdoing others in the same industry might be suspect. Some extreme examples are commodity businesses like metals and highly competitive industries like airlines. Those not reflecting similar earnings in response to economic conditions could be suspect. Financing and accounting choices might also send up red flags. "One suspect sign is a company with negative cash flows from operations coupled with earnings growth for multiple periods," says Trent Gazzaway, CPA, managing partner of corporate governance at Grant Thornton in Charlotte, N.C.

Keeping it simple
Financial statements also show how a company organizes itself. Those with complex structures might be trying to hide irregularities. "A significant number of unusual one-off transactions could mean a company is making things too complex," says Gazzaway.
Large companies with complex structures are less suspect than smaller ones that have less need for multiple divisions or entities. But simple structures are good business practices for all. "Take special note of companies with holding companies for every business unit that don't seem to have a business purpose," says Steven Blum, CPA, CFE, director at FTI Ten Eyck. "If those are offshore holding companies the red flag gets raised even higher."

Similarly, companies with an active merger or acquisition calendar create more opportunities for possible fraud. "A handful of companies that we have investigated got into trouble with the way they handled the cookie jar reserves set up after an acquisition or merger," says Blum.

Management's tone
The difference between managements that cross the line and those that don't is often the tone set by top executives. Blum points to the example of Tyco's trumpeting how they made the numerous unprofitable acquisitions profitable. "Company executives that brag too much about squeezing profits where there were none might just be putting undue pressure on employees to show results," says Blum.

An anti-fraud professional can't confirm the results of a boisterous CEO or CFO until the interviews with lower-level employees begin. But an overly confident executive who trumpets the meeting of each earning target does raise red flags.

Blum also points out that not all companies that might experience financial statement fraud have flashy CEOs. "One of Berkshire Hathaway's companies is currently involved in the accounting scandal at AIG," says Blum. "And no one can accuse Warren Buffett of being a braggart."

Finding the fine line between appropriate enthusiasm and undue pressure from top executives is a matter of experience. A CEO, after all, is hired to sell the company to the public. "Some of these guys come across as used car salesmen but actually have high ethical standards," says Gazzaway. "You should follow a gut feel that you don't trust that executive talking on TV but it takes a look at the financial statements to validate the mistrust."

Management sends signals of potential problems in other ways as well. "I watch for management flight," says Hagenbaugh. "When the vice president of marketing quits followed by the resignation of the VP of operations I take notice. These are inside people that may be seeing something they aren't comfortable with."

Hagenbaugh also pays attention to the president's letter in the annual report. If the numbers aren't tracking what the president is spending time explaining then something might be off. He likes to read the auditor's report for doubts expressed there. "Financial reports give clues to the tone at the top in how the executives express themselves," says Hagenbaugh.

Improved reports
This year's financial statements contain even more possible clues in SOX-mandated disclosures. Companies not complying with requirements for independent boards or those with ongoing control deficiencies are easily sighted. "Before I would have looked at revenue disclosures first but in today's world a quick look at governance is quite revealing," says Hagenbaugh. Hagenbaugh shared his experiences with SOX compliance at the 16th Annual ACFE Fraud Conference & Exhibition last July.

Board makeup tells the story about how a company approaches SOX compliance. Companies might differ in how they comply with the law. "We want management to exhibit that they're going to enforce SOX on themselves," says Hagenbaugh. "If we see a small audit committee of two people, or the appearance of all marketing professionals instead of finance professionals, we know this company isn't taking SOX seriously."
Hagenbaugh also looks for relationships among directors of different companies. "When we run into executives sitting on each other's boards we see that as a red flag," he says.
The tone of management's explanations of possible deficiencies might need an expert eye to discern but further clues might be found in these new paragraphs in SOX compliance disclosure. "An average Joe might not glean information from reading the disclosures," says Hagenbaugh. "But I look to see if any management attitude might be revealed that could work against the company's compliance."

Disclosures must be understandable to pass muster, according to Gazzaway. If the explanations are vague and incomplete, they throw up red flags. "Talk about material weaknesses or deficiencies should reveal the implications to the financial reports," he says. "Plus management should include clear steps about how they plan to address the weaknesses. ... A huge red flag, while rare, is when auditors say not only does the company have poor internal controls but evaluation processes are also deficient," Gazzaway says.

Surveys suggest that smaller companies show more weaknesses under SOX than larger ones. According to the May 2005 tally of the stocks of the Russell 3000® Index in the publication, Compliance Week, approximately 75 percent of the weakness disclosures came from companies with less than $1 billion in revenue. Only four companies making such disclosures had revenue of more than $10 billion: General Electric, Toys R Us, AIG, and The Great Atlantic & Pacific Tea Company. Smaller companies have until 2006 to comply with SOX and reports indicate that the costs of complying are prohibitive for some companies. (See the Compliance Week survey's report on company areas in which weaknesses were reported, below.)

Most agree it's too soon to tell whether the newly required disclosures add much to the fraud examiner's tool box. The greatest value might be in year-over-year comparisons of company's reports. "Next year the disclosures should be more efficient with less focus on the evaluations process," says Gazzaway. "Companies will be able to highlight areas specific to that company."

Early research bears out that investors perceive weaknesses to be negative and sell stocks of those companies. In a March 2005 study, "Internal Control Weaknesses and Information Uncertainty," authors found stocks of disclosing firms went down with the news.1 But other characteristics balanced out the negative effects in the universe of 366 companies in the survey. Companies with high-quality auditors declined less. Companies that had already demonstrated poor earnings quality with such items as an abnormally high accruals component were also less affected. Alternatively, additional bad news of auditor turnover and companies in industries with reputed bad earnings quality lent to bigger selloffs in companies with material weaknesses.

Even before a fraud examiner accesses company records he or she starts to form a profile of the client company. Certain conditions listed in this article can confirm suspicions of possible fraud. These indicators might not mean the company engaged in fraudulent practices, or that fraudulent accounting might occur at companies with none of these red flags. But the knowledge of these red flags helps a fraud examiner hone his or her nose for fraud.

Company areas in which weaknesses could lead to fraud
Based on 71 material weaknesses made in May of 2005. Some companies disclosed more than one weakness.

Source: "Compliance Week" 

1.  M.D. Beneish, M. Billings, L. Hodder. "Internal Control Weaknesses and Information Uncertainty," Kelley Scool of Business, Indiana University, March 1, 2005.  

Cynthia Harrington, CFE, CFA, is a contributing writer for Fraud Magazine.