Auditors are supposed to watch out for the red flags when they combing through a company's books. Put simply, if you have a number of these flags, the auditor should start having serious doubts about management. For external auditors, there are 42 red flags and if they fail to recognise them, it's most likely that they'll be deemed to have been negligent.

That's how it works in theory. But fraud still goes on and the question is why some auditors miss obvious signs.

To try and answer this, Glen D Moyes, Raymond M Landry Jr and Handan Vicdan from The University of Texas-Pan American, and Ping Lin and Ping Lin from California State University looked at how internal auditors rated these flags. Were some danger signals more important than others?

Their paper Internal Auditors' Perceptions of the Effectiveness of Red Flags to Detect Fraudulent Financial Reporting makes some interesting observations. Of the 42 flags, only 15 were rated as more effective than others. Another 14 were considered to be effective and 13 were considered to be ineffective. So 29 of the 42 flags are regarded as real danger signals. The rest? Nice to have there but not that important.

More importantly, the findings are relevant not only for auditors but for investors too. People who play the market should keep an eye out for these signs if they have money riding on certain companies, or if they are considering backing them.

According to the study, the biggest danger signs of a company on the brink of fraud are:

1.Excessive pressure from the CEO or board to meet financial targets.

2. A big chunk of management's compensation in the form of bonuses and options hinging on them meeting those targets.

3.Rapid growth or profitability when compared to competitors.

4.Unrealistic profit expectations coming through in press releases and annual reports.

5.Recurring negative cash flows or the inability to generate cash flows, despite reports of earnings growth.

6.Perceived or real adverse effects of bad results on up and coming transactions.

7.Restricting the ability of the auditor to communicate with people.

8.Significant related party transactions that are not in the normal line of business.

9.Domination of management by one person or a coterie.

10.Ineffective accounting and information systems.

11.Inadequate monitoring of internal controls.

12.Significant or highly complex transaction occurring close to year-end.

13.Management tries to influence the auditor.

14.A known history of violations of securities law or claims against the entity, management or board alleging fraud.

15.Ineffective communication, implementation and enforcement of the entity's purported values or ethical standards.

The paper doesn't really answer the question as to why some auditors still ignore the so-called more effective red flags.

Still, the real value comes from the researchers identifying and naming the big danger signs. It's not only the internal auditors who should watch out for them.