Things That Make Us Go “Hmmm”: 10 Red Flags in Business Fraud
By Kori Bogard, Kevin Marold, Serena Morones, Jennifer Murphy and Jennifer Prager — Our Forensic Accounting & Fraud Investigation Team
What are the warning signs of potential business fraud? Having done hundreds of accounting investigations involving various allegations of financial wrongdoing, our team has seen it all. Whether it’s a shareholder dispute or business sale that resulted in litigation, a divorce case, suspicion of financial statement fraud or employee embezzlement, we look under the hood to see what’s really going on.
Our team is brought in to reconstruct financial statements, identify misappropriated or personal expenses, and analyze both forensic accounting issues and business value. We determine the true profitability of a business by correcting and undoing bogus accounting entries and making adjustments for assets or liabilities that weren’t on the books.
With several decades of combined experience, we collectively identified our favorite red flags that point to potential business fraud.
1. Complicated accounting with balances moved between accounts
Normally, a business has routine transactions and expenses like utilities. When the books are clean, these numbers are straightforward without a lot of fluctuation. But we start to wonder what’s going on when books show expenses entered in one account, but the balance is moved and it’s difficult to get to the original transaction.
It may be that an inexperienced bookkeeper didn’t categorize expenses properly in journal entries. On the other hand, it could be that someone is trying to cover something up, like burying a large personal expense through the business to reduce their tax burden. Since an accountant cleans up their books at the end of the year, fraudsters try not to draw attention to unusual or large expenses. To hide an expense and avoid questions from their CPA, they may break out an expense as payments to multiple payees under various business expense categories in their journal entries.
We unwind and trace the expenses, looking at the QuickBooks file and actual credit card statements to understand where payments were made and whether the movement is appropriate.
“When we open up their books and see consistency and the same vendors, it’s not concerning. But when you see movement between accounts or expenses that fluctuate significantly, it’s a flag. At that point, we request the statements to see if they match the books and follow up with questions.” – Jennifer Prager
2. Credit card payments entered without transaction detail
We may find a monthly credit card bill was recorded as one payment/business expense without any detail as simply “cc expense.” Sometimes this is a red flag indicating that someone is trying to cover up amounts paid for personal expenses.
It is especially problematic when we discover personal expenses run through the business when the engagement involves:
- multiple members/shareholders involved in the business, as the personal expenses of one member can reduce profits for all of the members;
- a business owner in a divorce case, as the personal expenses can make a business look less profitable when buying out a spouse from the business.
Accounting records should indicate the purpose of an expense. Business owners benefit from having consistent accounting records to track expenses for planning purposes. It’s not useful to classify everything as a “cc expense.” Seeing where the money is spent is not only a good practice to prevent fraud, it helps owners make decisions for the company.
“The books should accurately reflect the company’s income and expenses, so generally the more detail the better. It’s about following the money and what actually happened, using accounting records as a guide but confirming with credit card statements, copies of deposits and canceled checks.” – Jennifer Prager
3. High year-end volume or number of transactions
We’ve seen cases where a company realizes it’s not performing as well as it wanted and records fraudulent transactions at the end of the year to increase its reported sales and improve its financial outlook. This happens most often when executives are heavily incentivized with bonuses for better financial performance.
A couple of things to look for when it’s suspected that sales or performance numbers are inflated:
- Use month-by-month data to compare year-end performance and numbers. Look at least at a couple of months leading to year-end to see if there are irregularities that can’t be explained. Retailers would expect to have a spike in sales during the holiday season at the end of the year while other types of businesses may not. There may be something legitimately happening in the economy or business that drove up demand, but typically a high volume of year-end transactions is a red flag.
- Look at the journal entries to see if they are inconsistent with how activity is recorded the rest of the year. When there are a lot of journal entries that record transactions, they are susceptible to fraud. Fictitious sales are often recorded there because they can be typed in manually. We’ve also seen sales booked for January recorded as December sales the prior year to increase numbers for the year.
“Companies should revisit how they evaluate performance and incentivize their managers and executives. If their compensation is structured to the point where a majority is dependent on how the company performs, there is more risk for fraud to take place.” – Kori Bogard
4. Suspicious cash disbursements
Those who have the power to write checks or issue payments on a company’s behalf sometimes abuse that power. One such method of abuse is authorizing cash disbursements to oneself or through cash withdrawals. Solid internal policies and controls that are effectively communicated and executed are ways to prevent fraud.
Things to look for:
- Large or disproportionate number of disbursements below approval thresholds. Company policy may exist which requires management approval of cash disbursements above a dollar amount threshold. Having thresholds can be an acceptable policy, but it’s also important to randomly select disbursements under these thresholds and require support/back-up for transactions.
- Even-dollar amount disbursements. People committing fraud tend to follow a repeatable and predictable pattern recording even dollar transactions. This is suspicious since expenses tend to come in various and uneven dollar amounts.
- Escalation of disbursements over time. A fraudster often starts small to see what they can get away with by starting with small amounts. It’s a red flag if you see increases in disbursements to a particular employee or company on a monthly or yearly basis that continue to rise for no good reason.
“Monitor disbursement activity by pulling reports to see how many disbursements are going to specific employees, companies, or to cash and how many are under the approval threshold. Compare those numbers with disbursements to employees in a similar role. If it looks like an unusual or high number, it’s worth looking into.” – Kori Bogard
5. Non-cash shareholder contributions
When a business needs an infusion of capital for its operations, it will most likely come from shareholder contributions. It’s a red flag when a shareholder contribution was in the form of an asset other than cash, especially because it’s often more difficult to determine what the non-cash asset was actually worth. The shareholder may have paid off an expense, absorbed a loan for the company, or given a vehicle. These are suspicious and appear as though someone is cutting corners, perhaps to avoid paying taxes or treat personal expenses as business expenses, and have often led us to discover dishonest activity.
“If a shareholder isn’t contributing cash, it may imply there is some kind of comingling and that the shareholder and business aren’t separate in their finances. It paints a picture of an unusually close relationship between the shareholder and the business.” – Kevin Marold
6. Adjustments made to accounting records for a previous year after financial statements are issued
It’s suspicious when we see financial statements with entries for a prior year after the business has already gone through the rigor of year-end close and its auditors have done the clean-up work for that prior year. Every year, net income gets closed out, is moved into retained earnings and the new year starts with a clean slate. There shouldn’t be any entries assigned to a prior year in the books.
In a recent case, expenses were altered several years later. The vendor name, expense and description had changed compared to the original entry, which was previously for personal benefit but was recharacterized years later to look like an expense with a valid business purpose. In another case, a business manager was accused of running personal expenses through the business but claimed it was because she wasn’t being paid by the business. We were brought in to see whether she was owed anything by the business in light of the self-dealing allegations.
“If there is a legitimate error that wasn’t recorded in a prior year, there is a way to correct it without restating the historical financials. Instead of going back and creating an entry during the prior year, the error should typically be included as a correction in the current year.” – Kevin Marold
7. Under compensation
Business owners sometimes choose to under-compensate an employee by agreement. We have seen this happen when the individual is a family member or was promised to receive something of value later. However, this can lead to higher risk that the under-compensated employee will make up for the shortfall through unauthorized self-dealing transactions. Under-compensation seems to lead to problems, including a sense of entitlement that the shortfall in compensation can be taken out of the business in non-traditional ways.
“Avoid placing employees in a position of feeling resentment or entitlement because they are paid less than market compensation. Fraud occurs when an individual rationalizes their improper actions. Under-compensation provides rationale to a potential fraudster.” – Serena Morones
8. Numerous bank accounts or related entities
When a company uses numerous bank accounts or related companies, financial transactions often become less clear due to constant moving of funds between accounts or companies. This can become a good cover for fraud, since complexity veils fraud. We’ve seen a pattern in business fraud where self-dealing transactions were funneled through a complex web of bank accounts and related companies.
“Keep money flow simple. Don’t open an additional bank account to keep track of a particular business activity. Use an accounting chart of accounts to track distinct business activities.” – Serena Morones
9. High volume use of company credit cards
We’ve seen a number of cases where a business provided company-issued credit cards to employees but didn’t have good policies or processes in place for documenting charges. When credit card use isn’t questioned, it is more prone to abuse and fraud. Given that any misuse of company funds through credit card use isn’t discoverable until after the money has already been spent, it is important to set up controls up front to limit unauthorized use.
Companies often treat company credit card expenditures differently than typical accounts payable disbursements or employee reimbursements, which commonly require documentary support such as receipts and approvals. However, the process should be the same, and the business should require documentation that supports the business purpose for expenses charged to a credit card. If employees sense a lack of controls over company credit card use, it can increase the risk that unauthorized charges can be made. It can be challenging and expensive to later investigate and determine whether the charges were legitimate business expenses or were for personal use.
“We worked on a case where a company thought there had been unauthorized use of company-issued credit cards. We found many instances where there was no contemporaneous documentary support for the charges, and a number of charges were for purchases that under some circumstances could be seen as personal in nature. It became difficult to distinguish between personal and business credit card use because there was little documentation to support any of the charges. This can be particularly problematic when expenditures involve vendors that can be common for both personal purchases and business purchases, such as Amazon. It is important for both tax purposes and fraud prevention to have a clear policy on company credit card use and to require appropriate documentation of expenses charged.” – Jennifer Murphy
10. Lack of oversight for accounting
Many small businesses are built around an owner-entrepreneur and a handful of supporting employees. Due to limited staff and resources, small businesses often have less sophisticated accounting processes and accounting oversight, and fewer internal controls than a larger company. When small business owners take little interest in the accounting process and rely solely on another trusted individual, it can pose a greater risk for fraud. It is not uncommon to read about small businesses that suffered embezzlement from a long-time, trusted accounting employee who was given full control over the financial aspects of the company.
“It’s important for any small business owner to review accounting reports on a routine basis. While many business owners find day-to-day accounting tasks unappealing and gladly hire someone else to perform this role, the owner should seek out the accounting reports that are most meaningful to them to assist them in monitoring the business. For example, this might be reports showing the top 10 vendors, customers and/or sales for the month. The owner should identify the type of reporting that is most impactful for them and aligns with the way they see the business to help them more easily recognize if something doesn’t look right.” – Jennifer Murphy