Review Reports - Auditing the Risk of Financial Fraud Using the Red Flags Technique

Round 1

Reviewer 1 Report

Comments and Suggestions for Authors

I have some suggestions to improve this work. 1) The authors should clearly explain the research gap, aims, contributions, and novelty of the present work in the abstract and introduction sections. 2) The results part should be explained by providing some support from prior studies. In the current format, the authors just report the results which is not enough. 3) The policy implications need to be expanded from the various perspectives. 4) Based on the study "The effects of institutional settings and risks on bank dividend policy in an emerging market: Evidence from Tobit model. International Journal of Finance & Economics, 2021, 26(3), 4493-4515." there are several types of firm's risks such as business risk. Is the suggested approach can be useful for other types of risks? I recommend the authors use the mentioned study and justify their results.

Comments on the Quality of English Language

It's good.

Author Response

Dear Reviewer,

We express our sincere gratitude for taking the time to review our research. Your recommendations and suggestions were highly valued and insightful. We have carefully considered all of them and taken the necessary steps to incorporate them into our work. Also, we reviewed the bibliographic sources in APA Style and completed the bibliography with new sources.

Your feedback has given us a valuable opportunity and improved our research. We are confident our changes will significantly enhance our findings' quality and accuracy.

In the manuscript, we have chosen to highlight the changes made by color (red).

Reply for Reviewer 1:

1.The authors should clearly explain the research gap, aims, contributions, and novelty of the present work in the abstract and introduction sections.

In the Abstract, the following paragraph was included: The purpose of this research is to conduct a comprehensive examination of both theoretical and practical aspects with the objective of determining the risk profile of financial fraud among auditors. This will aid in preventing, detecting, and correcting such harmful practices. Through an empirical study of a fraudulent corporate entity, the quality of information contained within financial reports will be assessed, as well as the effectiveness of managerial decision-making substantiation.

2. The results part should be explained by providing some support from prior studies. In the current format, the authors just report the results which is not enough.

In the Results Section, I made improvements in the final part of the case study and compared some of the results that I considered the most significant with other results of a company with a different object of activity. The following paragraph was included:

Lines 527-538: Analyzing the activity of operating operations, through the association between the speed of rotation of current assets and the presence or absence of fraud, it can be observed how a fraudulent entity records above-average values of this indicator, which leads to an increase in the efficiency of operational activities (increase in stock turnover that leads to an increase in customer receipts, to oversized values of the turnover and implicitly to higher values of the accounting result). In addition, the auditor must analyse the nature of current assets (inventory, receivables or treasury items, cash and bank accounts) to assess the entity's fraud risk in terms of asset theft. Therefore, the increase in the speed of rotation of current assets based on the turnover of stocks and finished products leads to operational efficiency (if receivables from customers will also be collected), and an increase based on treasury assets makes the entity prone to the risk of fraud, as can be seen from the results obtained in the present scientific study (Figure 6).

The policy implications need to be expanded from the various perspectives.

In Section 2 - Materials and Methods, we dealt with problems related to the political implications of the matter. New paragraphs were included:

Lines 231-245: One of the biggest challenges Romania faces in terms of fiscal policy and regulation is the lack of cohesion between these laws. Additionally, the laws themselves are often unclear and lack proper guidance for implementation. This creates opportunities for both financial auditors and user entities to evade tax laws and avoid fulfilling their financial obligations. Unfortunately, this can lead to fraudulent activities and the falsification of financial reports. The impact of these risks can have far-reaching consequences, including social inequality, a lack of trust in public authority, and a general distrust of those responsible for governing. To combat these issues, policies should be put in place that assess existing and potential risks, provide specific measures for prevention, detection, investigation, and prosecution of fraud, and allocate clear responsibilities for implementation and monitoring [31].

Management should also adopt a formal anti-fraud policy or statement, which outlines strategies for developing an anti-fraud culture and mechanisms for reporting suspected fraud. While red signals alert managers of potential issues, they are only an indication and require additional checks to confirm or deny potential fraud.

Lines 252-258: Numerous challenges and obstacles confront technology's ability to prevent financial crime and ensure compliance. These include a high rate of false positives, incomplete data from unstructured sources, a lack of analytical insight, and outdated rule-based detection methods. Additionally, delayed warning mechanisms can contribute to an increase in fraudulent activity. To address these concerns, data on previously detected fraud can be incorporated into the analysis, revealing patterns and trading techniques and leading to better decision-making that reduces both fraud and false positives [34].

Lines 318-325: In conclusion, effective risk management is one of the major lines of defense of an entity. The first step is to identify emerging, individual or emerging risks and assess the risk to measure the level of exposure. Second, it is necessary to identify the entity's risk culture, limit and establish early warning signs for violations of the entity's risk limits. Thirdly, it is necessary to carry out the monitoring and supervision of the activities that may cause the risks of the entity, propose risk mitigation actions and report to the designated authorities. Entities can also achieve good corporate governance through sound ethical practices and awareness [52].

Based on the study "The effects of institutional settings and risks on bank dividend policy in an emerging market: Evidence from Tobit model. International Journal of Finance & Economics, 2021, 26(3), 4493-4515." there are several types of firm's risks such as business risk. Is the suggested approach can be useful for other types of risks? I recommend the authors use the mentioned study and justify their results.

Thank you for your remarks; we relied on the study mentioned in Results Section. The following paragraph was included:

Lines 547-579: Various risks, including business, financial, and economic risks, can have a notable adverse effect on dividend payments and other areas. Our analysis, as shown in Figures 3, 4, 5, and 6, suggests a linear robustness that does not necessitate additional tests or alternative estimation procedures. Furthermore, we have found that risk has a statistically significant negative impact on payment policies and exploitation activities [59].

While some risks may be unforeseeable, they should not be overlooked. Instead, managers should allocate separate budget lines for unexpected situations and create reserves. Essentially, they should prepare for rainy days.

Risk management is a continuous, cyclical process, and the results obtained must be regularly monitored. Changes in context or new information can render the original assessment outdated.

As part of the auditing process, it is important for specialized studies to be consulted to determine the nature of debts, including associated costs, and the use of foreign resources. The accuracy of reported equity must also be evaluated. By analyzing the financing method used and the existence of fraud, it is possible to draw relevant conclusions about the entity's financial situation. In this case, the presence of financial fraud can be signalled by values of financing/self-financing rates that differ from the norm. For instance, a high Rai (Self-financing rate of fixed assets) and a low Rfei (Rate of external financing of fixed assets) may indicate fraud. The trend lines presented in Figure 4 for Rai, Rfei, and Rît (Total debt ratio) show an exponential or representative relationship for the analyzed financial indicators, which indicates a linear relationship between the independent and dependent variables.

After comparing these results to similar studies involving food trading activity, where low levels indicate fraud (Rai) and average levels indicate non-fraud (Rfei), the trend lines for the analyzed financial indicators show an exponential or representative pattern. Additionally, there is a linear relationship between the independent and dependent variables, indicating that entities affected by fraud had higher than average rates of term debt in the data sample. This extended working method, along with investigative tools, can provide a new solution to the challenge of fraud in the accounting profession. The use of statistical methods in financial and fraud auditing, as well as their interconnections with financial analysis and accounting, can lead to a broader and more sophisticated direction of research, including a more extensive range of indicators to accurately assess entity performance.

We hope that we have met the requirements of the revisions, and we are sending the revised form of this manuscript.

Authors

Author Response File: Author Response.pdf

Reviewer 2 Report

Comments and Suggestions for Authors This study aims to analyze auditors' financial fraud risk profile in preventing and detecting harmful practices, as identified through an empirical study of a corporate entity presumed to be fraudulent. Although it is an interesting topic, the authors must address the following points in detail for consideration to be published.

1. The red flag concept has a weak definition. Please widen the concept. What's new in it? What is the problem it addresses? Check the following studies:
- https://www.emerald.com/insight/content/doi/10.1108/JFRC-01-2021-0005/full/html
- https://www.tandfonline.com/doi/abs/10.1080/15427560.2011.575971

2. Based on the results. Is it possible to have an expanded definition of the red flag in the context of fraud?

3. The specific gap in the knowledge frontier, which this study wants to close, is unclear. Please elaborate more. Also, please indicate the contributions.

4. In order to have a better understanding of the contributions, the results have to be compared with previous studies. Please indicate which findings are the most important in the context of fraud red flags.

5. The contents of materials and methods are confused with research Methodology. Please give more information on the corporate entity and explain how results could change in different industries or countries.

6. A Literature review section must be added. Please cite paper Q1/Q2. Please check the following studies:
- https://www.sciencedirect.com/science/article/pii/S146708951630077X
- https://www.sciencedirect.com/science/article/abs/pii/S0278425419300730
- https://www.sciencedirect.com/science/article/pii/S2405844023106992
- https://www.sciencedirect.com/science/article/pii/S2667305323001199

7. The methodology used (Factor Analysis of Multiple Correspondences) must be explained in a wider way; it is only mentioned. Please make a robustness test.

8. In the Conclusion section, the authors mentioned that " At the same time, analyzing "red flags" and combating those signals of a financial or non-financial nature (of financial or non-financial indicators) is an audit trail that allows fraud auditors to detect these culprits" (lines 466 to 468). It is unclear what non-financial indicators were used. Indeed, these indicators were not defined.

9. Further studies must be defined.

10. Please elaborate on how results could help decision-makers.

11. I believe that the results section does have a deeper analysis. Please elaborate more and justify them.

Author Response

Dear Reviewer,

Your feedback has given us a valuable opportunity and improved our research. We are confident our changes will significantly enhance our findings' quality and accuracy.

In the manuscript, we have chosen to highlight the changes made by color (red).

Reply for Reviewer 2:

The red flag concept has a weak definition. Please widen the concept. What's new in it? What is the problem it addresses? Check the following studies:
- https://www.emerald.com/insight/content/doi/10.1108/JFRC-01-2021-0005/full/html
- https://www.tandfonline.com/doi/abs/10.1080/15427560.2011.575971.

We have improved the Introduction and Materials and Methods Sections. New developments of the concept were added by identifying new bibliographic sources. Thank you for the suggestions sent by you. For example, the paragraphs:

Lines 124 – 140: Based on our preceding statements, we as authors of this scientific approach have contributed by assessing the fraud risk associated with a financial profile. This achievement leads to the prevention and detection of potential fraudulent activities through the identification of signal elements using the Red Flags technique, as illustrated in the case study.

After analyzing the factors mentioned above, it is important to note that financial indicators play a significant role in detecting fraud during an audit. These indicators act as red flags and signal the presence of fraudulent activity, allowing for timely detection [20]. Red flags can be identified through various means, such as analyzing annual financial statements and calculating indicators of liquidity, solvency, profitability, and structure. Quantitative methods can provide valuable insights into the risk and fraud mechanisms at play. It is crucial for entities to disclose the possibility of financial fraud and continuously raise awareness to prevent potential risks, including the latest fraud schemes. Additionally, having a crisis management strategy in place is essential to deal with any crisis situation. This should include a structured response protocol and a specific action plan tailored to the situation at hand, in order to minimize potential financial losses and reputational damage

Lines 161-171: Red flags serve as warnings or indications that a company's financial reports or statements may be problematic, indicating risks of economic or financial information manipulation. To mitigate risk, different activity levels and geographical areas must be considered [22]. The term "red flags" is a metaphor, commonly used to signify concerns or warning signs in a particular situation, such as business or investments. These flags can alert investors and analysts about a company's future financial health and economic troubles. However, there are no universal standards for identifying red flags, as it depends on the analytical method used by the investor, analyst, or economist. Red flags can be found in quarterly financial statements and may require additional research and analysis to recognize. It is advisable to review triennial reports to make informed investment decisions [23].

. Based on the results. Is it possible to have an expanded definition of the red flag in the context of fraud?

After developing the concept in the Materials and Methods Section, in the Conclusion Section we try to have an explanation using paragraph:

Lines 596-613: While analyzing "red flags" and combating financial signals may be seen as a daunting task, it is an essential part of an audit trail that helps fraud auditors detect and prevent culprits. If left unchecked, fraudulent actions can have a negative impact on an entity's profits, profitability, and overall sustainability. To perfect decision-making models, it is crucial to have access to reliable information and to continually adapt to new dynamics and factors. The cost of obtaining and preserving this information must also be taken into consideration, as well as the time available for decision-making. By gathering and utilizing relevant information, entities can make informed decisions that maximize benefits and ensure long-term success.

This information is primarily intended for those making decisions about new product development and future marketing campaigns, which rely heavily on the power of information. However, when it comes to investors and other stakeholders, providing every possible detail and value isn't necessary. Instead, they prefer a clear overview of trends and perspectives that are relevant to their needs.

In today's world, where investors balance short-term financial results with long-term economic entity goals, it's crucial for businesses to prioritize their perfor-mance. The decision-making process is at the heart of management activities and affects all functions, as well as the integration of the entity into the competitive environment and its ability to navigate economic crises. High-quality decision-making also leads to reduced costs, efficient use of funds, increased profits, and more.

The specific gap in the knowledge frontier, which this study wants to close, is unclear. Please elaborate more. Also, please indicate the contributions.

Improvements to the present gap study and contributions are detailed in the Introduction Section. New references were added.

Lines 52-72: In ISA 240, it is emphasized that preventing and detecting fraud is primarily the responsibility of those in charge of governance and management. When conducting an audit in accordance with ISAs, the auditor has a duty to provide reasonable assurance that the financial statements are free from fraudulent activity. It is important to note that the "expectation gap" issue is commonly analyzed in audits of financial statements or audit tasks. However, given the changes in international standards and the introduction of the concept of "assurance tasks," it is necessary to consider the various types of tasks that authorized auditors may perform during the audit process.

The issue of the "expectation gap" is often not thoroughly examined in relation to other tasks due to their unique nature. However, it is crucial to investigate this issue considering the various engagement portfolios that currently fall under published International Standards for Quality Control, Audits, Limited Reviews, Other Assurance Engagements and Related Services, including audits of historical financial information, limited reviews of historical financial information, assurance engagements other than audits or reviews of historical financial information, and related services. Conversely, certain types of consulting or advisory services fall outside the regulation of IAASB standards. Therefore, we recognize the need for a comprehensive study of the expectation gap that considers the full scope of tasks performed by certified auditors. This gap has been acknowledged since the 1970s and has been extensively studied by both academics and professionals. Its components were initially proposed by Porter [3, 4] and were further analyzed by others [5, 6].

In order to have a better understanding of the contributions, the results have to be compared with previous studies. Please indicate which findings are the most important in the context of fraud red flags.

We have improved the presentation of the study in the Results Section to better understand our contributions and results.

Risk management is a continuous, cyclical process, and the results obtained must be regularly monitored. Changes in context or new information can render the original assessment outdated.

The contents of materials and methods are confused with research Methodology. Please give more information on the corporate entity and explain how results could change in different industries or countries.

Further details on the analyzed entities have been incorporated in the Research Methodology Section, while the Materials and Methods Section elucidates the fundamental concepts and pertinent literature. We appreciate your insightful observation on the potential comparability of results with particular industries or countries, which could serve as a basis for future research. Thank you for your contribution.

A Literature review section must be added. Please cite paper Q1/Q2. Please check the following studies:
- https://www.sciencedirect.com/science/article/pii/S146708951630077X
- https://www.sciencedirect.com/science/article/abs/pii/S0278425419300730
- https://www.sciencedirect.com/science/article/pii/S2405844023106992
- https://www.sciencedirect.com/science/article/pii/S2667305323001199

Thanks for the suggestions. In Section 2 Materials and methods, additional information was added that also refers to the specialized literature from the recommended materials. See the References Section, no. 34, 52.

The methodology used (Factor Analysis of Multiple Correspondences) must be explained in a wider way; it is only mentioned. Please make a robustness test.

In Section 3, we provided thorough explanations of the research methodology utilized. After careful consideration, I deemed the robustness test unnecessary and, therefore, removed the following paragraph which discussed analyzing and assessing the risk of fraud in financial audits using economic models. The following paragraph was added:Lines 345-361: To achieve the research objectives of the study, a positivist approach was used [53], which is a logical type model [54], carried out with the help of economic models for the factor analysis of multiple correspondences and the assessment of the risk of fraud in the financial audit mission. Factorial analysis of multiple correspondences is a complex mathematical technique that is part of the group of tools for quality management, established by the Japanese under the name matrix data analysis. The factor analysis diagram allows to give a visual representation of the correlations between multiple variables, being possible to visualize on a plane what is happening in a space with n dimensions. So, robust correlation (non-parametric correlation) is used to detect monotonic relationships between variables, namely: when one variable increases only when the other increases, or decreases only when the other increases only, but not necessarily in a linear manner. Drawing from the challenges highlighted in specialized literature surrounding the analysis and evaluation of fraud risk in financial audit missions, a set of comprehensive and practical testing and verification studies are recommended. Given the significance of financial indicators, including factors such as structure, profitability, solvency, and liquidity, in identifying errors in financial statements, we suggest leveraging this information to gauge the potential for fraud related to the examined entity.

In the Conclusion section, the authors mentioned that " At the same time, analyzing "red flags" and combating those signals of a financial or non-financial nature (of financial or non-financial indicators) is an audit trail that allows fraud auditors to detect these culprits" (lines 466 to 468). It is unclear what non-financial indicators were used. Indeed, these indicators were not defined.

Thank you for your attention. This is an error that has been corrected. Improvements and corrections based on your observations have been made in the Conclusion Section.

Lines 586-593: Based on the results obtained from our scientific approach and the validation of the proposed hypothesis (that there is a significant relationship between the rates proposed by the analysis and the presence or absence of financial fraud), the purpose of this study was fulfilled by identifying the financial profile of the risk of fraud. This feature is useful for auditors in financial audit operations, especially fraud audit operations, to test the presence of fraud at the level of audited entities. Finally, this feature can also be used for the prevention and control programs of sensitive areas that can generate fraud to entities vulnerable to fraud risks.

Further studies must be defined.

Thank you for observation. The following paragraph was included with further studies.Lines 622-628. One potential avenue for future research is to conduct a comparative analysis of red flags in this topic or related topics across various industries or countries. Additionally, further investigation into identifying potential fraud or major financial risks through the analysis of "red flags" in company financial reports, as well as studies exploring how investor reactions to these signals impact investment decisions, could be valuable. Finally, evaluating the efficacy of financial education and training in recognizing and managing "red flags" in investment contexts may also be worth exploring.

10. Please elaborate on how results could help decision-makers.

In Conclusion Section were included paragraphs for this aspect:

Lines 594-613: While analyzing "red flags" and combating financial signals may be seen as a daunting task, it is an essential part of an audit trail that helps fraud auditors detect and prevent culprits. If left unchecked, fraudulent actions can have a negative impact on an entity's profits, profitability, and overall sustainability. To perfect decision-making models, it is crucial to have access to reliable information and to continually adapt to new dynamics and factors. The cost of obtaining and preserving this information must also be taken into consideration, as well as the time available for decision-making. By gathering and utilizing relevant information, entities can make informed decisions that maximize benefits and ensure long-term success.

In today's world, where investors balance short-term financial results with long-term economic entity goals, it's crucial for businesses to prioritize their performance. The decision-making process is at the heart of management activities and affects all functions, as well as the integration of the entity into the competitive environment and its ability to navigate economic crises. High-quality decision-making also leads to reduced costs, efficient use of funds, increased profits, and more.

11. I believe that the results section does have a deeper analysis. Please elaborate more and justify them.

The Results section was improved with more analysis:

Risk management is a continuous, cyclical process, and the results obtained must be regularly monitored. Changes in context or new information can render the original assessment outdated.

We hope that we have met the requirements of the revisions, and we are sending the revised form of this manuscript.

Authors

Author Response File: Author Response.pdf

Reviewer 3 Report

Comments and Suggestions for Authors

1. The topic of the study is interesting and relevant. However, the authors should clarify the problem and the aim of the study in the introduction, as the introduction currently presents the problem in a very general way and it is not clear which aspect the authors are investigating. Now, from the title of the paper (and the empirical study carried out), it would seem that the authors want to show the importance of the red flags technique and the process of its application in determining the probability of financial fraud. And they used data from one corporation as an example of the application of the red flags technique. However, there is no mention of the importance and application of this technique in either the abstract or the introduction. On the other hand, maybe the authors see the problem of revealing the probability of financial fraud in a particular corporation, and the red flag technique is just one possible tool. In that case, the introduction should emphasise why it is important to disclose the probability of financial fraud of this particular company.

2. The chosen research method is appropriate. However, it was not clear from reading the article how Table 1, which shows not only the financial ratios used but also their ranges, was compiled. According to the reference under Table 1, it would seem that these indicators were developed by Jaba and Grama (2004) and adapted by the authors of article. However, a glance at this source (pages 87-90) shows that the information provided there relates to the coding of the data using SPSS and not to the financial ratios. According to the text of the paper (see lines 262-263), it would seem that Table 1 was developed by the authors themselves on the basis of their professional experience. However, the question then arises as to how the authors of the article determined that these are the appropriate indicators to reveal the probability of financial fraud and that these are the appropriate ranges that indicate a certain level of probability. In this way, a broader commentary on the indicators in Table 1 would be desirable (maybe similar studies using these indicators have already been carried out; maybe this justification has already been published somewhere, etc.).

3. Perhaps line 392 should read "In Figure 4..."

Author Response

Dear Reviewer,

Your feedback has given us a valuable opportunity and improved our research. We are confident our changes will significantly enhance our findings' quality and accuracy.

In the manuscript, we have chosen to highlight the changes made by color (red).

Reply for Reviewer 3:

The topic of the study is interesting and relevant. However, the authors should clarify the problem and the aim of the study in the introduction, as the introduction currently presents the problem in a very general way and it is not clear which aspect the authors are investigating. Now, from the title of the paper (and the empirical study carried out), it would seem that the authors want to show the importance of the red flags technique and the process of its application in determining the probability of financial fraud. And they used data from one corporation as an example of the application of the red flags technique. However, there is no mention of the importance and application of this technique in either the abstract or the introduction. On the other hand, maybe the authors see the problem of revealing the probability of financial fraud in a particular corporation, and the red flag technique is just one possible tool. In that case, the introduction should emphasise why it is important to disclose the probability of financial fraud of this particular company.

Thank you for the exposure made for this work. In this sense, we proceeded to improve all sections by introducing new paragraphs that lead to a better understanding of the research. All the details requested based on the observations made have been include in the Introduction Section in new lines:

Lines 30-33: The topicality of the topic consists in identifying the ways to make managerial decisions more efficient based on the information from the financial reports in order to ensure their quality and correctness, extremely important information in a constantly changing economic environment.

The chosen research method is appropriate. However, it was not clear from reading the article how Table 1, which shows not only the financial ratios used but also their ranges, was compiled. According to the reference under Table 1, it would seem that these indicators were developed by Jaba and Grama (2004) and adapted by the authors of article. However, a glance at this source (pages 87-90) shows that the information provided there relates to the coding of the data using SPSS and not to the financial ratios. According to the text of the paper (see lines 262-263), it would seem that Table 1 was developed by the authors themselves on the basis of their professional experience. However, the question then arises as to how the authors of the article determined that these are the appropriate indicators to reveal the probability of financial fraud and that these are the appropriate ranges that indicate a certain level of probability. In this way, a broader commentary on the indicators in Table 1 would be desirable (maybe similar studies using these indicators have already been carried out; maybe this justification has already been published somewhere, etc.).

Table 1 reflects the systematization activity of suitable indicators to reveal the probability of financial fraud and was carried out by the authors. The reference Jaba and Grama (2004) was the basis for establishing the probability thresholds that were used in the paper. The expertise of the cited authors was used in the process of data transposition in the financial coding system through the use of computer programs.

Perhaps line 392 should read "In Figure 4..."

Thank you for your attention. This is an error that has been corrected.

We hope that we have met the requirements of the revisions, and we are sending the revised form of this manuscript.

Authors

Author Response File: Author Response.pdf

Round 2

Reviewer 2 Report

Comments and Suggestions for Authors

The authors have significantly enhanced both the content and analysis of the paper. I suggest that the paper is ready for publication.