FAR 740/741

FINANCIAL STATEMENT ANALYSIS

RF – PERCEPTION OF AUDITORS

A Literature Review

Prepared for:

Dr. Intan Waheedah Othman

Prepared by:

Ahmad Tamim Ab Kadir 2019607864

 INDEX

ITEMS PAGES

INTRODUCTION 1-3

LITERATURE REVIEW 3-4

METHODOLOGY 5-6

FINDINGS 7-8

CONCLUSION 9-10

REFERENCES 11

II
 INTRODUCTION

What id Red Flag?

Red Flag is a set of circumstances that are unusual in nature or vary from the normal activity.
According to Elliot and Willingham (1980), red flags (RF) can be understood as actions,
surroundings, conditions, compressions, chances, coercions or personal characteristics that may
upsurge the risk of managing fraud. Even though it may not inevitably point out the occurrence of
fraud, they are circumstances supposed to be normally existent in actions of fraud and might
consequently propose that distress may be justified. It is a signal that something is out of the ordinary
and may need to be investigated further.

Robertson (2002) said that it is indicate the situational burdens such as unexpected reductions
in income or market share, or impractical budget stresses which giving the signal that the risk of
financial statement fraud increases extensively. Besides, Kaplan and Reckers (1995) propose that
variables and fluctuations in organisation’s life style, additional benefit reimbursement plans and
flaws in the internal audit department may be gauges of financial statement fraud. It could be
wised to not ignore a red flag and may be sometimes and error is just an error. Therefore, for this
article review, it will be discussed on the perception of auditors towards the RF.

5 Selected Articles

To discuss further regarding the perception of auditors, there are five selected articles that
represent different countries. These five articles will be looking on the perception of auditors in
United States of America, Malaysia, Lebanon, India and Hong Kong. The selected articles are as
follows:

1. The differences in perceived level of fraud-detecting effectiveness of SAS No. 99 RF

between external and internal auditors by Moyes (2007).
2. Malaysian internal and external auditor perceptions of the effectiveness of RF for detecting
fraud by Moyes, Young and Mohamed Din (2013).
3. Auditors perceptions towards the effectiveness of the international standard on auditing 240
RF: evidence from Lebanon by Hijazi and Mahboub (2019).
4. Auditors’ perception of red flag: Indian evidence by Mangala and Kumari (2016).
5. An analysis of Hong Kong auditors’ perceptions of the importance of selected red flag factors
in risk assessment by Majid, Gul and Tsui (2001).

1
Article 1

For introduction, according to Moyes (2007), in this article the study is aimed to examine the
view of usefulness of RF in the discovering of fraudulent financial statements among external and
internal auditors in United States of America. Also, stated that by Moyes (2007), this study tries to
recognise any dissimilarities among external and internal auditors in their viewed fraud-descovering
usefulness as refer to SAS no. 99 RF. Moreover, Moyes (2007) want to explore the question which
number of auditors may notice RF to be unproductive in spotting falsified motion, whereas other
auditors ponder the similar red flag as much operational in fraud detection.

Article 2

For the second article, Moyes, Young and Mohamed Din (2013) want to observe the
usefulness of US SAS no. 99 RF in identifying fraud as perceived by both Malaysian internal and
external auditors. Moyes, Young and Mohamed Din (2013) also stated that SAS No. 99 and
International Standards on Auditing oblige external auditors to practice RF in noticing fraudulent
financial reporting doings, whereas leading financial statement audits.

Article 3

Next, Hijazi and Mahboub (2019) stated in their article that most of the studies on auditors’
awareness towards the helpfulness of the International Standard on Auditing 240 RF were piloted in
developed and less study was conducted in developing country and third world country. For that,
Hijazi and Mahboub (2019) stated that their study was to conclude whether red flag can be
supportive for Lebanon Certified Public Accountant (LCPA) which working in auditing firms by
spotting fraudulent financial reporting.

Article 4

Following, the study of auditors’ perception towards RF in India was conducted by Mangala
and Kumari (2016). The research conducted by Mangala and Kumari (2016) was aims to know
alertness level about red flag among Indian auditors. Other than that, Mangala and Kumari (2016)
wanted to detect auditors’ perception about usefulness of red flag in fraud deterrence and detection.

2
Article 5

For the fifth article, the study conducted by Majid, Gul and Tsui (2001) aimed to examine
auditors’ perceptions of the relative level of risk of fraud and material irregularities associated with
the presence of six red flag factors and also evaluated the quality of auditors’ judgements. Also, their
study wanted to examine Hong Kong auditors’ perceptions of the degree to which they look the
existence of particular RF in a precise assumed situation as gauges of the presence of fraud and
inaccuracy.

LITERATURE REVIEW

Article 1

For the first article by Moyes (2007), Albrecht and Romney (1986) gave that auditors
professed that less than half of the RF were measured important forecasters of cheating. While,
Heiman-Hoffman and Morgan (1996) highlighted the information that RF did convey dissimilar
loads as alleged by the sample of auditors and this can be seen through the results exhibited the
auditors be likely to valuate “management attitudes” (dishonesty) by way of the greatest vital type of
RF matched to supplementary managerial issues. Other than that, Pincus (1989) displayed that
merely half of the auditors practiced red flag surveys in supporting in the deception valuation, from
the time when they measured RF a significant instrument in the auditing process. Nevertheless, some
shall think of non-practice of red flag surveys shows these accountants might not observe RF as a
gauges of falsified doings. Additionally, Hackenbrack (1993) concluded that auditors allocated
mainly to bigger client appointments employed higher concern on aspects (RF) connecting with the
chances of making dishonesty than auditors inspecting small companies.

Article 2

In the second article, research suggests that the use of RF is effective for finding falsified
financial reporting (Hegazy and Kassem, 2010; Moyes, Lin, Landry and Vicdan, 2006). Other
studies demonstration that not entirely RF are similarly operative for spotting fraud, so that internal
and external auditors remark the fraud detection usefulness of RF in a different way (Heiman-
Hoffman and Morgan, 1996; Moyes, 2006). In addition, Moyes et al. (2006) found that internal
auditors’ see ‘attitude’ or justification RF as utmost operative for fraud detection. As well, Albrecht

3
and Romney (1986) stated that audit partners perceive RF associated with individual features of
organisation as operative for fraud finding but perceive company-specific RF to be ineffectual for
fraud discovery. Besides, Apostolou, Hassell, Webber and Sumner (2001) delivered that auditors
remark RF correlated to individual features of management and encouragement over the control
situation as most effective for fraud detection.

Article 3

For article three by Hijazi and Mahboub (2019), it had been stated by Yücel (2013) that
external auditors must retain pathway of some gauges (RF) and apply dissimilar methods in
determining manipulations. He also suggested that recognising the important alert indications (RF)
must aid the external auditors in accomplishment improved valuation of fraud risk. Other than that,
Moyes, Young and Din (2013) identified that external auditors have to define the activities that are
measured as RF, which can point out to the stresses or encouragements, attitudes or justifications,
and chances to commit fraud. On the other hand, Kassem and Higson (2012) proclaimed that the ISA
(240) inspires the external auditors to realize reflection together the outside and inside features that
effect the firm and may produce stress, chance, and generate a situation that allows directors or staffs
to justify committing fraud.

Article 4

In the article four by Mangala and Kumari (2016), stated in their article by Gullkvist and
Jokipii (2013) which identified that some of single red flag cannot be underscored in all the
circumstances. Besides, the RF credentials escalations auditor’s thoughtfulness near fraud occurrence
(Krambia-Kaparis, 2002). Furthermore, auditors who distinctly evaluate fraud threat give extra
consideration to RF and improve feeling toward fraud (Zimbelman, 1997). Additionally, stressed
auditors running connection actions as an important gauges (RF) of possible fraud (Moyes, Lin,
Landry and Vicdan, 2006).

Article 5

RF can be defined as “potential symptoms existing within the company’s business

environment that would indicate a higher risk of an intentional misstatement of the financial
statements” (Price Waterhouse, 1985, p. 31). Besides, the presence of these red flag elements is
predictable to distress the auditors’ valuation of intrinsic risks, which in turn, will affect the
prearranged exposure risk (Colbert, 1987, 1988). In line with that, in early 1970s, Touche Ross
planned a set of caution indications (RF) for fraud founded on economic elements and business

4
structure elements (Pincus, 1989). Additionally, some study found that the “signals” or RF are used
extensively by auditors (Konrath, 1989).

METHODOLGY

Article 1

In this study, Moyes (2007) obtained a list of members from the American Institute of
Certified Public Accountants (AICPA), which two thosands surveys were conducted. For the internal
auditors, Moyes mailed the survey to the GAIN, an association of the Institute of Internal Auditors
(IIA), which roughly one thousand eight hundred internal auditors who are membership of GAIN
and dispersed through the US. Assessment information were put together ended a half year period.
Also, both comeback rates are reasonably low for two causes which are the red flag survey was much
lengthy of its dimension, and it is a problematic matter for external and internal auditors to know
plus selected capability to assess its usefulness. Additionally, the accountants might assess the degree
of cheating spotting usefulness of red flag respectively by applying Likert scale. Other than that,
Moyes use Mean, Variance, Regression, T-tests and the Wilcoxon Rank Sum to conclude whether
major variances occurred among auditors internally or externally which refer to their alleged degree
of usefulness of RF as forecasters of problematic financial statement.

Article 2

Meanwhile, for article 2, Moyes, Young and Mohamed Din (2013) collected a total of 52
Malaysian internal auditors and 40 Malaysian external auditors answer the questionnaire. The
external and internal auditors completed and returned the questionnaire. In addition, the researchers
use Mean and T-tests to conclude whether substantial dissimilarities occurred amongst the auditors
as refer with the degree of perception that function as forecasters of cheating action.

Article 3

In this article, the researchers decided to choose the sample of the field study which is 10% of
the population. Hence, 130 surveys were circulated amongst Lebanese Association of Certified
Public Accountants (LACPA) that are working in the firms. Moreover, the researchers used a survey
as a technique for gathering information. Likewise, the selected research instrument is the Likert
scale which applied to the scheme of the survey. Other than that, Hijazi and Mahboub (2019) apply
Cronbach’s alpha values, Correlation Analysis, Regression Analysis and One-Sample Wilcoxon
Signed Rank Test in order to analyse the gathered information. The one-sample Wilcoxon employed

5
rank assessment is a non-parametric substitute to one-sample t-test once the data cannot be
anticipated to be normally dispersed. It's also used to define whether the median of the sample is
identical to a recognised ordinary rate for example theoretical value.

Article 4

The sample taken in the research of article 4, it includes working chartered accountants who
are employed in dissimilar audit organisations and involved in any type of audit work. 100 auditors
were met. Out of which, 90 auditors replied to the survey. On the other hand, ten auditors, who did
not reply, said that they have not ever used or attended about the theory of red flag. Henceforth, the
survey was complete through inter personal relations to auditors. The privacy to respondents was
guaranteed which encourages them to honestly answer the survey and escalations the consistency of
the questionnaire. Like any other research, Cronbach’s alpha values, Mean, T-tests and Tukey post
hoc analysis were used to analyse the information. Tukey's range test, also known as the Tukey's test,
Tukey method, Tukey's honest significance test, or Tukey's HSD test, is a single-step several
assessment technique and numerical test. It can be used to discover means that are suggestively
diverse from each other.

Article 5

In this study, the researchers selected partners and managers in three prominent CPA firms
which consist of 3 audit partners, 11 audit managers and 12 audit seniors in Hong Kong and have
decided to support in the introductory review. The survey used in the preliminary survey, indicate the
probability of material misstatements by using a 7 point Likert-type scale (1: not important; 7: very
important). Next, in the second stage of the study, elements were selected for the lens model study.
The lens model initiated in Egon Brunswik’s theory of probabilistic functionalism, which is mainly a
theory of perception. Matters for the lens model study were volunteer auditors from a cross-section
of Big 6 audit firms in Hong Kong who did not contribute in the introductory questionnaire survey.

6
 FINDINGS
Article 1
The finding for article 1 is that 42% of the outer auditors may had spotted cheating using RF
then might not be persuaded of their fraud spotting usefulness. In addition, extra skilled internal
auditors be likely to evaluate the usefulness of RF greater than less skilled internal auditors. Also,
there was no implication in perceived fraud-detecting usefulness were examined between the
numerous stages of training for both set of auditors. Moreover, the external auditors’ professed
usefulness of RF is important, while inner auditors’ alleged cheating discovery usefulness of RF is
insignificant. Other than that, there is no implications were sighted on behalf of outside auditors in
terms of the company’s dimension where the auditors work with. Contrary, internal auditors was
speculated that the bigger companies would tend to set up extra importance on RF because of their
customer base, consequently amassed the significance and perceived usefulness. Furthermore,
women higher compared to men may take to consideration of RF as extra operative so as in
identifying cheating and dodge severe complications when a false doings remained happening
however didn’t spot for outside and inside auditor.

Article 2
The Malaysian external auditors (means: 3.40; 1st rank is insufficient separation of
responsibilities or self-regulating checks) remark a broader choice of fraud spotting usefulness of the
29 opportunity RF than the Malaysian internal auditors (means: 3.00 maximum; 1st rank is huge sums
of moneys on hand or treated). Next, external auditors (means: 3.23 maximum; 1 st rank is
administration and/or board of directors getting substantial monetary concern in the company) notice
a extensive kind of diverse ranks of the fraud discovering usefulness of the 15 pressure RF than the
internal auditors (means: 2.71 maximum; 1st rank is different accounting or constitutional or
supervisory necessities). Also, external auditors (means: 2.98 maximum; 1 st rank is irrational burdens
on the auditor, such as irrational period limits concerning the accomplishment of the audit) notice a
varied range of dissimilar stages of the fraud distinguishing usefulness of the 15 rationalisation RF
than internal auditors (means: 2.73 maximum; 1st rank is unnecessary attention by administration in
upholding or growing the company’s share price or earnings tendency).

7
Article 3
In article three, an optimistic substantial connotation between pressures red flag and
fraudulent financial reporting incidence in Lebanon. Following, there is a positive important
relationship between degree of opportunities and fraudulent financial reporting happening in
Lebanon. Contrary, a negative important relationship between attitudes or justifications and
fraudulent financial reporting occurrence in Lebanon. Therefore, ISA 240 Red Flag for fraudulent
financial reporting can assist external auditors in perceiving fraud in Lebanon.

Article 4
Auditors in India were detected to be alert about red flag but in minimum degree due to
information that Indian auditors might not consider regarding occurrence of any of their duty toward
fraud discovery. Also, respondents in this study were of the opinion that red flag supports in fraud
detection nonetheless they were disagreeing about occurrence of red flag shows real occurrence of
fraud. The Indian auditors in state audit firms were extremely alert of RF matched to local firms.
Besides, Indian auditors with fewer experience especially freshly practiced chartered accountants
think red flag as greatly effective in contrast with auditors with extraordinary experience.

Article 5
In Hong Kong, misstatements identified in previous audits were alleged by auditors to be the
greatest significant element in detecting the risk of substantial mistakes and anomalies. While, the
next important red flag is a sign of going-concern issue, which might be affected by supplementary
aspects containing organisation fraud. Whereby the other four remaining RF such as contentious
accounting matters, difficult-to audit trades, organisation working style and organisation view on
financial reporting had comparatively small for that reason, not observed by respondents as very
significant as indications of fraud and abnormality.

8
 CONCLUSION
Article 1
Outside auditors look to view RF has much operative commonly for searching cheating
compared to inside auditors. Also, the outside auditor view that major pointers of RF usefulness that
measured real use of RF for example expose to RF, how frequently an auditor practises RF, the
management’s usefulness in term of applying RF, plus the function of RF to discover dishonesty. On
the other hand, highly skilled inside auditors accepted that forty two RF may have more operational
in discovering fraud compared to lower skilled internal auditors. Generally, women auditors valued
the RF constantly more operative in the discovering of fraudulent action than men auditors. Although
the survey was pre-examined and certified, it is still probable that roughly misunderstanding of the
queries may have happened. Furthermore, the answer received was small, hence the respondent shall
not become demonstrative of the others in US.

Article 2
While the perception of Malaysian auditors see that each RF as taking a dissimilar degree of
fraud discovering usefulness. Generally, Malaysian external auditors perceive a marginally wider
array of diverse degrees of fraud detecting success of opportunity, pressure and rationalisation RF as
compared to Malaysian internal auditors. Additionally, the most number of important variances (12
out of 59 RF) in the awareness of RF usefulness among Malaysian external and internal auditors
occurs in the classification of opportunity RF.

Article 3
Eventually, the result in Lebanon delivers a robust proof that ISA 240 RF for fraudulent
financial reporting may assist external auditors in identifying fraud. Moreover, the number of
detailed RF for fraudulent financial reporting that stayed applied in this research can be practiced in
combination with SAS 99 RF to improve external auditors’ skill in discovering fraudulent financial
reporting. Unfortunately, the researchers were not capable to receive other than 130 LACPA
employed in the audit firms out of 1300 LACPA to answer the survey and therefore the findings
cannot be generalized to all members of LACPA in Lebanon. The researchers recommend the
members of LACPA employed in the audit companies in Lebanon to emphasis their hard work more
on great quality RF, which shall sequentially expedite fraud discovering in the financial statements.

9
Article 4
The study in India present that the massive significance to regulator, accounting
professionals, directors and scholars, which highlights the status of red flag in fraud detection and
avoidance. Additionally, the view toward usefulness of red flag has been deliberated which is
founded on their work skill so their prior knowledge and individual biasness can upset their reaction.
Additionally, in Indian situation, fraud risk controlling is a reactive approach which the controlling is
based on reacting to occasions afterward they have occurred. Factually, around 41% companies in
India did not taking proper fraud risk management framework (KPMG, 2010). The results of this
study highlighted that accounting supervisory organizations Institute of Chartered Accountants of
India (ICAI) and Institute of Cost & Works Accountants of India (ICWAI), to take actual measures
to spread responsiveness regarding red flag amongst accounting experts and demonstrate them so
that be aware of red flag and to proceed effective moves on its existence.

Article 5
As refer to the study done in Hong Kong, it can be realize that the topics were drained from a
cross-section of the Big 6 firms in Hong Kong and their awareness may not replicate the opinions of
the group of auditors in Hong Kong and elsewhere. Besides, the inauthenticity and
uncomplicatedness of the investigational condition could have touched the outcomes. This study also
offers some visions into auditors’ views and resolutions about red flag elements was steered in two
phases. In addition, this research also offers some introductory indication concerning the role of
heuristics and probabilistic functionalism in the auditors’ resolution making method.

10
 REFERENCES

Elliott, R. K., & Willingham, J. J. (1980). Management fraud: Detection and deterrence. New York:
Petrocelli Books.

Robertson, J. C. (2002). Fraud Examination for Managers and Auditors (2002 ed.). Austin, TX:
Viesca Books.

Kaplan, S., & Reckers, P. M. (1995). Auditors′ reporting decisions for accounting estimates.
Managerial Auditing Journal.

Moyes, G. D. (2007). The differences in perceived level of fraud-detecting effectiveness of SAS No.
99 RF between external and internal auditors. Journal of Business & Economics Research
(JBER), 5(6).

Moyes, G. D., Young, R., & Mohamed Din, H. F. (2013). Malaysian internal and external auditor
perceptions of the effectiveness of RF for detecting fraud. International Journal of Auditing
Technology, 1(1), 91-106.

Hijazi, W., & Mahboub, R. (2019). Auditors perceptions towards the effectiveness of the
international standard on auditing 240 RF: evidence from Lebanon.

Mangala, D., & Kumari, P. (2016). Auditors’ Perception of Red Flag: Indian Evidence.Mangala, D.
& Kumari, P.(2016). Auditors’ Perception of RF: Indian Evidence. In Usha Arora, Deepa
Mangala& UbbaSavita (Eds.), Management Mosaic Traversing Across Assorted Research
Arena, 97-111.

Majid, A., Gul, F. A., & Tsui, J. S. (2001). An analysis of Hong Kong auditors' perceptions of the
importance of selected red flag factors in risk assessment. Journal of Business Ethics, 32(3),
263-274.

KPMG. (2010). India Fraud Survey Report. India: KPMG Forensic.

11