More Red Flags for Detecting Circular Cash Flow

BY STEVEN NICOKIRIS, CPA

In the article “Detecting Circular Cash Flow” (Dec. 09, page 26), I found the facts of the case study using Moxie Alloys to be extremely interesting and thought provoking. I thought the authors did a nice job explaining the exposure to a lender as well as the auditor’s risk surrounding accounts receivable (“A/R”), including red flags.

 

However, I felt the article failed to describe other key considerations and interrelationships of financial statement accounts  to be considered by an auditor in a financial statement audit. I think excluding these considerations leaves the reader with a gap in the true process of planning and performing an audit in accordance with the guidelines of the profession. Examples would include an understanding of the company’s business, integrity of management and strength of internal accounting controls.

 

The article did not include how the fraud could affect other related accounts—the most obvious being inventory, sales and cost of goods sold—and steps the auditor might consider.

 

Since the article indicated that there was a material overstatement in assets (that is, A/R), I believe there would likely be other red flags during the course of the financial statement audit that the auditor would need to address:

 

  • The relationship between purchases and inventory.
  • Analytical review procedures, including inventory turnover and gross profit reconciliations, relationship of borrowings to inventory and payable levels, and overall profitability.
  • Analytics related to other financial statement accounts related to increasing sales (such as shipping/distributions costs, selling/commission costs and cash flow).

 

In summary, I enjoyed reading the article, but I felt the authors’ focus on only A/R did not fully describe the role of an auditor in a financial statement audit in detecting a fraud using the circular cash flow technique.

 

Steven Nicokiris, CPA

New York City

 

Authors’ reply: Our intent in writing this article was to describe the circular flow of cash fraud scheme and emphasize the most pertinent audit areas (accounts receivable and sales) that would provide key red flags to assist in detecting such a scheme. As such, we did not intend this article to represent an all-inclusive outline of the audit process; rather, the article was designed to outline key considerations with regard to this scheme to an audience already familiar with base audit guidelines.

 

Other red flags specifically noted within Mr. Nicokiris’ comments may very well surface when this type of fraud scheme is being perpetrated. However, red flags found in these other areas tend not to be as blatant as the overstatement of revenue and accounts receivable. Changes in account balances and their interrelationships among other accounts occur when a business experiences revenue growth. However, what makes this scheme so difficult to detect is that the same changes occur whether the growth is real or the result of this scheme.

 

As mentioned in the article, attention to professional skepticism and due care while executing all phases of the audit provide one of the greatest tools in detecting fraud in general; however, establishing existence of the receivables is the single most important thing that can be done to identify this particular scheme.

 

John F. Monhemius, CPA

Cleveland

and Kevin P. Durkin, CPA

Parsippany, N.J.

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