As was highlighted in the 1990 CICA research report Approaches to Dealing with Risk and Uncertainty, management's motives and intentions can significantly affect the quality of financial reporting. The literature identifies a number of common fraudulent financial reporting practices, as well as legal but deceptive -- perhaps unethical or at least questionable -- reporting practices. Entities in financial distress may attempt to abuse accounting principles in order to hide impending insolvency or contraventions of debt covenants by delaying reports, adopting income increasing accounting policies, and so on. Therefore, when an entity is either already in financial distress or is approaching it, the assumption of management's good faith can come into question.

A US study of changes in the application of accounting principles by financially distressed entities during the 1974-1980 time period found that, in comparison with a matched sample of "healthy" entities, distressed ones made nearly twice as many material changes in general, and over four times as many material income increasing changes as healthy entities. The most frequent changes were switches to LIFO and pension changes. The author's explanation is that while switches to LIFO lower earnings per share, they can improve an entity's cash flow through a reduction in taxes. Changes in pension accounting usually involved expense and liability decreasing changes in actuarial assumptions (e.g., assumed rate of return on pension assets and pattern of expenditure) and methods used to calculate pension liability.

A study of the accounting policies used by the failed Canadian Commercial Bank (CCB) identified five specific accounting decisions that prevented the CCB's insolvency from coming to light much earlier than it otherwise might have, including:

• avoiding or delaying recognition of loan losses by delaying reclassification of loans as non- performing as long as possible, using unrealistic values for collateral, and making work-out agreements for loans in danger of becoming non-current;
• recognizing fee and interest income from renegotiated / uncollectible loans;
• making insufficient transfers of retained earnings to the Statement of Appropriations for Contingencies despite increasing loan loss experience;
• use of income tax recoveries to more than offset losses without sufficient assurance that there would be future taxable income; and
• recording the excess of purchase price over the book value of the assets as goodwill upon the purchase of another bank, rather than an offset against anticipated losses on the write down of the purchased bank's loans, and amortizing the goodwill over the maximum period allowable under GAAP.

While the percentage of bankruptcies that involve fraud is not large, there is an important correlation between management fraud, business failure, and legal action against auditors. Litigation against independent auditors takes place in the context of allegations of audit failures which, in turn, often take place in the context of business failures and management fraud.

A study covering the 25-year period 1960-1985 involving the 15 largest US audit firms identified 472 legal cases alleging audit failures. Of these, about 50% involved either bankruptcy or severe financial difficulties. This does not imply that when a business failure occurs the auditors always get sued. By working in the opposite direction, identifying bankrupt clients of these same 15 firms over the period 1970-1985 and then checking whether they involved litigation, the study found that only about 20% of the bankruptcies involved litigation against the auditors.

Instead, a key additional finding was that the majority of the lawsuits involving bankrupt clients also involved management fraud. These cases were most frequently resolved through payment of damages by auditors, in contrast with cases of business failures without management fraud which were most frequently resolved by dismissal of the case. (As an aside, the study found that dismissals of actions against auditors were less frequently reported in the media than resolution of legal cases by damage payments.)

Further evidence about the relationship between management fraud, business failure and audit reporting is provided by a study of 134 public company bankruptcies between 1974 and 1985. This study found that the highest incidence of fraud reported after the audit report date was in the group of bankrupt companies which did not give prior indication of distress and which had not received any qualification. The 118 bankrupt companies which had given some indication of financial distress prior to bankruptcy, regardless of whether they had received qualified or unqualified opinions, had a lower incidence of hidden fraud than the 16 non-distressed bankrupt companies which had not received qualifications. Indeed, these 16 companies had a much higher incidence of hidden fraud than a matched sample of 160 non-bankrupt companies (i.e., about five to six times as high), suggesting that the 16 companies did not show prior indicators of financial distress because the financial statements were manipulated and did not receive qualifications because the auditors did not uncover the management fraud.

Of these 118 companies, 54 financially distressed companies which ultimately went bankrupt and had received qualifications had a higher incidence of hidden fraud than the 64 distressed bankrupt companies which had not received qualifications. This suggests that auditors' qualifications may have been linked to their suspicion of hidden fraud, and not just the financial distress experienced by the entities in the sample. On the basis of these findings, the authors of this study suggest that procedures designed to identify management fraud can be effective in connection with "going concern" assessments as well.

An important characteristic of management fraud is that the fraud is perpetrated at levels of management above those to which internal control systems generally relate. Therefore, if an assessment of management fraud indicators or red flags leads the auditor to conclude that further investigative procedures are required, such procedures must be substantive, and no reliance should be placed on the system of internal control (Grinaker 1980). In other words, once the auditor cannot rely on management bona fides, then the auditor probably cannot rely on internal control either. Fortunately, Loebbecke et al. (1989) found that substantive tests of details were the most effective audit procedures in revealing irregularities.

The management fraud indicators used by Risk Alert are divided into three groups :

• conditions
• motivations
• attitudes

The indicators in all three groups require true or false answers.

Some of the management fraud indicators are similar to indicators in other categories. If the other indicators have been answered previously, the corresponding management fraud indicators will be pre-answered. These are denoted by an asterisk beside the True/False indicator . If the value for a pre-answered indicator is changed, a warning message is displayed showing the related indicators and requesting that the responses to the displayed indicators be modified to ensure agreement.

The risk indicators listed here can be used in several ways. The most obvious way is to rely on the checklist of indicators, identifying their presence or absence in a binary mode and coming to an overall judgment about the probability of financial misrepresentation prior to planning additional audit procedures. A second way of using the indicators is to focus on the sub-set of indicators found to be significant by Bell et al. and to give them greater emphasis. A third way is to use the Loebbecke et al. model, which requires not only that indicators be present, but that they be present in each of the three areas identified as Conditions, Motives, and Attitudes. This model provides an explicit role for ethics in moderating opportunistic behaviour: in the absence of indicators of poor attitude/poor business ethics, the auditor can accept the assumption of good faith and take advantage of this assumption.