Red Flag Series (4 of 5) – Red Flags in a Large Company

No matter how “good” a kid is, they will get into trouble. It is a fact of life. It is how we learn. When they are toddlers, they may use a marker to write on their baby sibling. As a 4 or 5 year old, they may cut their sibling’s hair or their own. These are relativity minor problems because markers can be washed off and hair grows back. However, as teenagers, the mistakes they make can have more significant consequences—some of which may not be fixed or corrected easily. I worry about this more and more every day now that I have a teenager under my roof. You may have heard the saying, “The bigger the kids, the bigger the problems.” 

This is similar when it comes to fraud in companies. The saying could be changed to “The larger the company, the larger the potential fraud.” While all companies have a risk of fraud, some have a higher risk than others. A $100K fraud has a greater impact to a smaller company than to a bigger company, but it is still $100K. However, a larger company has more money at risk and more people depend on the company’s success, which could yield a greater ripple effect from the fraud.

This post will address some of the red flags to look out for in a large organization, and these red flags are warning signs for fraud that could significantly impact the organization. The following could be signs of accounting fraud:

• Overriding controls – With a more complex internal control environment, there are more people involved in the accounting for transactions. Therefore, it usually takes several employees to override controls. This could happen in one of two ways: 1) collusion by several employees or 2) higher-level executive(s) telling others to ignore the controls to process transactions. However, one person could override the controls if they have enough power within the organization. There could be a legitimate reason for this occurring, but it should not be a regular occurrence.
• Aggressive accounting estimates – Business leaders are constantly looking for ways to enhance profitability, and aggressive accounting estimates are a fairly easy way to accomplish this goal. A simple example of this would be estimating allowance for doubtful accounts at 1 percent of receivables, when historical averages are closer to 5 percent. There are many other accounting estimates that impact the financial statements, and it is easy for management to make aggressive decisions. These short-term decisions may become disastrous for the long-term success of the organization.
• Overly complex transactions – In business, there is oftentimes a need for complex transactions, but be careful when the transactions are so complicated that they are difficult to understand either through their structure or their purpose. A few things to look for in determining if a transaction may be a red flag would be difficulty in understanding its structure or if the purpose is to gain more favorable accounting treatment (to work around the rules) or if the reason for the other party entering into the transaction isn’t clear. Journal entries should also be analyzed with a similar skepticism.
• Close relationships with outsiders – It is common for employees, managers, and executives to have close relationships with customers, vendors, or professionals from service firms (accounting or law firms). However, these relationships can get too close and may cloud the clarity of an arms’-length transaction or the perception of independence. Fraud can happen when lines are crossed and relationships with outsiders begin to blur the intentions of the parties. The success of the individuals within the relationships becomes a higher priority than the businesses’ success.

Most, if not all, of these have been present in the most significant accounting frauds that have occurred in our recent history. When evaluating these red flags, I would like to remind the CPAs of two foundational principles included in the House of GAAP: substance over form and conservatism. These two should help you evaluate whether some of these red flags exist. If you see one or more of these red flags, you should look closer to see if you can identify any others. Also, be sure to get others engaged to assist with understanding the root cause of these red flags. 

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