Management can perpetrate fraud in several systematic ways that auditors must vigilantly watch for during any audit engagement. Recognizing these methods—and associated red flags—helps auditors detect and prevent material misstatements and protect stakeholders.
Common Ways Management Commits Fraud
Manipulation of Revenue
- Premature Revenue Recognition: Recording sales before goods are shipped, services completed, or all revenue recognition criteria are met.
- Fictitious Sales: Inventing revenue through fake customers, phantom shipments, or non-existent transactions.
- Channel Stuffing: Shipping more goods to distributors than they can sell, just to book higher revenues in the current period.
Expense and Liability Manipulation
- Understating Expenses: Delaying the recognition of genuine expenses or capitalizing normal operating costs to artificially inflate profits.
- Failing to Record Liabilities: Omitting or understating obligations such as payables, accruals, or contingent liabilities to hide the true financial state.
Asset Valuation and Overstatement
- Overstating Assets: Inflating the value of inventory, receivables, or intangible assets beyond their recoverable amounts.
- Improper Capitalization: Recording routine expenses as long-term assets on the balance sheet.
Journal Entry and Adjusting Entry Fraud
- Unusual or Unsupported Journal Entries: Making end-of-year or unsupported adjusting entries with limited documentation, often to "smooth" earnings or hide losses.
- Mirror Payments and Suspicious Vendors: Creating duplicate payments or fictitious vendors to misappropriate company funds.
Management Override of Controls
- Override of Internal Controls: Management can bypass key controls, such as reviewing or approving payments, adjusting entries, or financial results, enabling fraud that might otherwise be caught.
Off-Balance-Sheet and Disclosure Fraud
- Hidden Entities: Using shell companies or special-purpose vehicles to conceal debt or losses from main financial statements.
- Improper Disclosures: Omitting or misrepresenting material information in notes to accounts or management discussions, misleading investors and regulators.
Red Flags Auditors Should Notice
- Rapid or unexplained jumps in revenue or profit not aligned with industry peers.
- Significant, unexplained changes in accounting policies or key estimates.
- Frequent unusual or large adjusting journal entries, especially near period ends.
- Discrepancies between reported profits and cash flows from operations.
- Related party transactions not conducted at arm’s length, inadequate disclosure, or conflicts of interest.
- Opaque or missing supporting documentation for large payments, expenses, or capital projects.
- Poor segregation of duties (e.g., employees responsible for both creating and approving payments).
- Repeated audit adjustments, restatements, or auditor resignations.
Vigilance for these schemes and signals is critical for auditors to fulfill their professional responsibilities and uphold trust in financial reporting.
