Red Flags and Accounting Warning Signs

Question 1

What are three major reasons management may be motivated to overstate earnings?

Answer 1

1. To meet analyst expectations,
2. Remain in compliance with debt covenants
3. Higher reported earnings will increase their compensation.

Question 2

What are four reasons management may be motivated to understate earnings?

Answer 2

1. To obtain trade relief,
2. Renegotiate advantageous repayment terms with existing creditors,
3. Negotiate more advantageous union labor contracts,
4. “Save” earnings to report in a future period.

Question 3

What four activities results in low earnings quality?

Answer 3

1. Selecting accounting principles that misrepresent the economics of transactions,
2. Structuring transactions primarily to achieve a desired effect on reported earnings,
3. Using aggressive or unrealistic estimates and assumptions
4. Exploiting the intent of an accounting standard.

Question 4

What are the three components of the fraud triangle?

Answer 4

1. Incentives and pressures (motive)
2. Opportunities (weak internal control system.)
3. Attitudes and rationalizations (mindset that fraud is justified.)

Question 5

What are four risk factors related to incentives and pressures for fraud?

Answer 5

1. Threats to the firm’s financial stability or profitability.
2. Excessive third-party pressures on management.
3. Threats to the personal net worth of management or board members.
4. Excessive pressure on management and employees to meet internal targets.

Question 6

What are four risk factors related to opportunities for fraud?

Answer 6

1. The nature of the industry or operations.
2. Ineffective monitoring of management.
3. Complex or unstable organizational structure.
4. Deficient internal controls.

Question 7

What are eight risk factors related to attitudes and rationalizations for fraud?

Answer 7

1. Inappropriate or inadequately supported ethical standards.
2. Excessive participation by nonfinancial management in selecting accounting methods.
3. A history of legal and regulatory violations by management or board members.
4. Obsessive attention to the stock price or earnings trend.
5. Aggressive commitments to third parties.
6. Failure to correct known compliance problems.
7. Minimizing earnings inappropriately for tax reporting.
8. Continued use of materiality to justify inappropriate accounting.
9. A strained relationship with the current or previous auditor.

Question 8

What are some common sign of revenue manipulation?

Answer 8

1. Aggressive revenue recognition.
2. Different growth rates of operating cash flow and earnings.
3. Abnormal comparative sales growth.
4. Abnormal inventory growth as compared to sales.
5. Moving nonoperating income and nonrecurring gains up the income statement to boost revenue.
6. Delaying expense recognition.
7. Excessive use of off-balance-sheet financing arrangements including leases.
8. Classifying expenses as extraordinary or nonrecurring and moving them down the income statement to boost income from continuing operations.
9. LIFO liquidations.
10. Abnormal comparative margin ratios.
11. Aggressive assumptions and estimates.
12. Year-end surprises.
13. Equity method investments with little or no cash flow.