Analyzing the effectiveness of red flags to detect fraudulent reporting

Journal of the Academy of Business and Economics, Jan, 2009 by Glen D. Moyes, Lawrence P. Shao, Michael Newsome

1. INTRODUCTION

Corporate governance has been an increasingly important part of the business environment as the actions of some major corporations have resulted in significant financial losses by shareholders. In particular, the financial collapse of such companies as WorldCom, Enron, Adelphia, Tyco and Conseco provided the impetus necessary to pass the Sarbanes-Oxley Act of 2002 and the accompanying Statement of Auditing Standard No. 99 (SAS 99) in 2002. Today, accountants are required to use 42 red flags to conduct audits of financial statements in an attempt to detect fraudulent financial reporting and thereby prevent losses for shareholders. This study examines the degree of effectiveness of the 42 red flags in determining fraudulent financial reporting.

The financial collapse of WorldCom, Enron, Adelphia, Tyco and Conseco involved numerous irregular financial reporting practices. Fraudulent accounting methods were used to mask declining earnings and to improperly report positive financial growth and profitability levels which inflated stock prices. Offshore entities were also used to avoid paying taxes and increase profit levels. All these events lead to major revisions in the federal auditing standards that must be used to detect fraudulent activities by corporations. The 2002 Statement of Auditing Standard No. 99 has increased the auditing requirement to a higher level and stipulates that examiners must use 42 red flags in financial statement audits to determine if fraudulent reporting exists. With higher standards comes greater responsibility and due diligence for auditors. Increased efforts to detect fraud are needed to protect corporate shareholders from potential unscrupulous activities by management. The agency relationship that exists between management and shareholders has lead to the need for more stringent auditing requirements.

In October 2002, the Statement of Auditing Standards No. 99 (SAS 99) was issued by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA). SAS 99 was designed to consider fraud activities as it relates to financial statement audit and analysis. After the financial collapse of many seemingly prominent corporations, stricter auditing standards were needed to protect the interests of corporate shareholders. SAS 99 is specific and more encompassing than the previous requirements established in SAS 82. SAS 99 defines fraud as a deliberate act that results in a material misstatement in financial statements. Fraud can be considered either misstatements that result from fraudulent financial reporting or misstatements that occur from misappropriation of assets. According to SAS 99 the three conditions that must be present for fraud to exist include the incentive to commit fraud, the opportunity to commit fraud and the ability to rationalize the fraud.

One method used to measure the effectiveness of fraud-detecting red flags is to use rating scales where auditors report their impression to red flags. Questions can address a wide variety of issues related to fraud detection including internal control methods, turnover of board directors, management attitude toward auditors and unusual profit levels. In this study, we use a similar survey rating scale to measure fraud-detection effectiveness. This research study surveyed accounting professionals who included both internal and external auditors. The majority of the respondents surveyed are accounting professionals who graduated with a bachelor degree in accounting.

The purpose of this study is to explore the level of effectiveness of 42 red flags required by SAS 99 to detect fraudulent financial activities. Additionally, this study analyzes the relationships among these 42 red flags and various demographic factors such as country of origin, income level, race, sex, undergraduate major, advance degree, type of firm, and years of auditing experience. The ability to detect fraudulent financial reporting by corporations represents increasing problems for auditors. Research studies conducted on fraud detection techniques used by accounting professionals will enhance our understanding of which factors have the most influence in detecting fraud.

2. LITERATURE REVIEW

Many studies have examined various methodologies used by auditors to detect fraudulent financial reporting associated with corporations. Moyes (2007) found no differences between external and internal auditors regarding the overall perceived level of fraud detecting effectiveness. However, he found that 17 of the 42 red flags had significant differences regarding the effectiveness of red flags in detecting fraud. For external auditors, the extent of use of red flags was a significant predictor of perceived effectiveness. For internal auditors, perceived fraud detecting effectiveness was a function of total audit experience.

The American Institute of Certified Public Accountants (AICPA) (2002) issued a financial auditing statement known as the Statement on Auditing Standards No 99: Consideration of Fraud in a Financial Statement Audit (SAS 99). SAS 99 describes fraud as a purposeful act that results in a material misstatement in financial statements. The two primary types of fraud include misstatements resulting from fraudulent financial reporting (e.g. falsification of records) and misstatements resulting from misappropriation of assets (e.g. stealing of assets). SAS 99 refers to the three "fraud triangle" conditions of incentive, opportunity and attitude that must exist for fraud to occur.