Financial Statement Red Flag Checklist

Financial Statements Fraud is used to make a company’s earnings look better on paper. The most common reasons why Financial Statements Fraud is committed:
• To demonstrate increased earnings per share or partnership profits interest, thus allowing increased dividend/distribution payouts
• To encourage investment through the sale of stock
• To cover inability to generate cash flow
• To dispel negative market perceptions
• To obtain financing, or to obtain more favorable terms on existing financing
• To receive higher purchase prices for acquisitions
• To demonstrate compliance with financing covenants
• To meet company goals and objectives
• To receive performance-related bonuses

The five classifications of financial statements schemes are:
1. Fictitious Revenues – recording of goods or services sales that did not occur
2. Timing Differences – recording of revenue and/or expenses in improper periods
3. Improper Asset Valuations – fraudulent overstatement of inventory and/or receivables, manipulation of the allocation of the purchase price of an acquired business, misclassification of fixed and other assets, or improper capitalization of inventory or start-up costs
4. Concealed Liabilities and Expenses – increasing pre-tax income by the full amount of the expense or liability not recorded, therefore having a significant impact on reported earnings
5. Improper Disclosures – misleading a general public member of the financial statements by one or more of the following: Liability Omissions, Subsequent Events, Management Fraud, Related-Party Transactions, and Accounting Changes

Red Flags Associated with Financial Statements Fraud:
• Domination of management by a single person or small group without compensating controls
• A practice by management of committing to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts
• Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management or the communication of inappropriate values or ethical standards
• Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth
• Rapid growth or unusual profitability, especially compared to that of other companies in the same industry
• Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions
• Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm
• Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality
• Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee