Exposing Financial Statement Fraud and Identifying Red Flags

This article aids auditors, investors, and regulators understand the motivations behind fraudulent financial statements, facilitates the identification of red flags, and highlights the implications for regulators, auditors, management, investors, lenders and academicians.

This verse states that people follow an unjust path to accumulate wealth to fulfil their hundreds of desires. The Association of Certified Fraud Examiners, in its Report to the Nations 2024 (hereinafter, ACFE 2024), has observed and reported ‘living beyond means’ as the most common and number one behavioural red flag found among fraud perpetrators. Frauds result in unlawful gains for fraud perpetrators; resultantly, companies lose value in stock market and consequently investors stand to lose their hard-earned money and employees lose their jobs. According to ACFE 2024, financial frauds can be committed through misappropriation of assets, corruption, or financial statement frauds (FSF). As reported by ACFE 2024, FSF amounted to a meagre 5 percent of the total 1,921 occupational frauds covered from 138 countries during the period from January 2022 to September 2023, but resulted in the highest median loss of $7,66,000 per case as compared to other types of losses. In light of this data, the aim of this article is to provide the motivations of fraudsters to manipulate financial statements and a classification of red flags of potential fraud found in the sections of the annual report of a company that may help users with the early detection of FSF to help them make informed decisions.

FSF involves intentional manipulation of financial statements to mislead the users for the preparers’ own illicit motives. Auditing Standard 2401: Consideration of Fraud in a Financial Statement Audit (AS 2401) states that fraudulent financial reporting can be done by manipulation, falsification, or alteration of accounting records, misrepresentation or intentional omissions, or intentional misapplication of accounting principles.

¹ Issued by Public Company Accounting Oversight Board of United States of America (PCAOB of USA)

Motivations to Commit Financial Statement Frauds

It is important to understand the motivations for committing FSF as they help in implementing corrective and preventive measures within a company. Donald Cressey, in his book ‘Other People’s Money,’ developed the fraud triangle that identifies the presence of three factors i.e., pressure, opportunity and rationalization that motivate a person to commit fraud.

• Pressure – when management is under internal and/or external pressure to manipulate financial statements to achieve unrealistic earnings targets, and consequences of not achieving these targets may be detrimental to them.
• Opportunity – when an individual believes that there lies an opportunity to use the presence of a loophole in the firm.
• Rationalization – the ability of individuals to rationalize the act of fraud.

In light of these motivations, following are the motivations that may drive management to manoeuvre financial statements.

1. Compensation Gains – Internal pressures are exerted on the managers through the design of executive compensation tied to stock options, remuneration, bonuses, promotion, and job security, which pressurizes the managers to commit FSF to secure compensation gains. Managers display their loyalty towards the company by misrepresenting FS under the pressures of top-level management to ensure job security.
2. Sustaining Financial Health Internally – In order to conceal the poor financial health of the business from external stakeholders, managers indulge in false reporting of high earnings to evade debt covenant constraints, meet unrealistic internal financial commitments related to sales, profitability, and rapid growth and offset high interest costs for as long as possible. The threatened profitability conditions (financial distress or bankruptcy) may propel managers to manipulate or conceal the deteriorating financial performance and health of the business. Managers are motivated to commit FSF to make a new strategy succeed to showcase their leadership qualities and to avoid adverse consequences (layoffs, retrenchment, demotions) resulting from poor financial reporting.
3. Protecting Market Confidence – Managers are under external pressure to protect market confidence in the business and therefore report inaccurate earnings that are in line with external earnings forecasts. The introduction of national and international regulations that are adverse to the business, cut-throat competition, and rapid changes in industrial and technological environment act as external pressures to motivate managers to indulge in FSF to maintain the financial credibility of the company and to avoid getting delisted from stock exchanges or having to sell their own holdings in the company at a higher price.
4. Optimizing Capital Structure and Tax Strategy – Under constant external pressure from external stakeholders (investors, lenders) to optimize the capital structure and to minimize tax liabilities, managers may be propelled to manipulate earnings. In order to raise external financing at low cost or to avoid debt covenant restrictions, managers are motivated to indulge in earnings management and also to obtain tax incentives.

While internal users are more interested in knowing about the motivations to falsify financial statements in order to maintain control or reduce motivations, external users are more inclined towards gaining knowledge of red flags to protect their self-interests.

Managers are motivated to commit FSF to make a new strategy succeed to showcase their leadership qualities and to avoid adverse consequences (layoffs, retrenchment, demotions) resulting from poor financial reporting.

Red Flags

According to Forensic Accounting and Investigation Standards (FAIS) No. 330 – Conducting Work Procedures issued by the Institute of Chartered Accountants of India (ICAI) as on 1^st July 2023, fraud risk indicators or red flags are “events or conditions that indicate an incentive or pressure to commit fraud (the motive) or provide situations to perpetrate one (the opportunity).” AS 2401 uses the fraud triangle approach to classify red flags on the basis of pressure, opportunity and rationalization. The Implementation Guide on FAIS No. 120 – Fraud Risk categorizes fraud risk indicators on the basis of importance (high/medium/low). The ACFE 2024 identifies behavioural red flags.

The red flags are identified using the Implementation Guide on FAIS No. 120 – Fraud Risk issued by the ICAI as on 1^st July 2023, AS 2401 issued by the PCAOB of the USA, orders issued by the Securities and Exchange Board of India, and various research papers on red flags. The published financial statements of a company are the first-hand source of information available to the external users to extract red flags and make informed decisions. The users may look into the annual report of a company comprising the auditors’ report, Management Discussion and Analysis, and financial statements consisting of the balance sheet, profit and loss statement, and cash flow statement.

Independent Auditor’s Report

The red flags include:

• Revelation of auditors about management’s integrity, override of management controls, high management turnover and disclosures by auditors regarding restrictions on or non-access to company information.
• A qualified opinion mentioning irregularities or doubts about the going concern status of a company, or a pattern of identical audit adjustments appearing in the qualifications year after year.
• Disclosure related to failure to conduct quarterly audits and discrepancies in audit committee constitution.
• Resignation of statutory auditors.
• Qualification on non-adherence to Indian Auditing Standards (Standards on Auditing 230 – Audit Documentation) by internal auditors.

Balance Sheet

Common red flags to be observed:

• Overstated and unjustified assets (e.g. inflated inventory, fictitious receivables), or unexplained increase in intangible assets in comparison with peer group companies.
• Any mismatch between investments in long-term assets in comparison with competitors and misapplication of the conservatism principle related to recording assets at cost or market price.
• Failure to recognize or disclose impairment of assets in contravention of the Indian Accounting Standard (Ind AS) 36 – Impairment of Assets.
• Exponential increase in the trade receivables or overstatement of debtors.
• Recording of a contingent asset (e.g. insurance claim which is under legal process and whose outcome is uncertain) in non-compliance with Ind AS 37 – Provisions, Contingent Liabilities and Contingent Assets.
• Advances/investments given by the company to entities that are declared defaulter by the Ministry of Corporate Affairs (MCA) and non-provisioning for impairment of assets (like advances and investments in struck off companies).
• Incorrect capitalization of R&D costs as assets.
• Undervalued or concealed liabilities (e.g. unrecorded accounts payable or contingent liabilities).
• Unexplained increase in capitalized expenses, continuous rollover of loans, misstated reserves or provisions (e.g. warranty claims), and inadequate allowance for doubtful debts.
• Non-provisioning for long-outstanding balances.
• Recording notional losses from derivatives trading under the heading of current liabilities.
• Misrepresentation of the value or condition of collateral used to secure a loan.
• Unsecured loans (without any collateral) to shell entities with no clear business connection, that are non-existent, have no assets, offices, or operations, or to high-risk businesses having dummy addresses and common email addresses.
• Set off of debtors and creditors done without routing of payments through banks.
• Default on loans.

Statement of Profit and Loss

Fraud indicators to be observed:

• Outstanding results when the rest of the industry has suffered a downturn, or unusually fast expansion along with abnormally high profits compared to industry standards and competitors.
• Issues related to revenue recognition such as premature revenue recognition, recording fictitious sales or overstating sales without supporting documents. Increase in quantity of sales without increase in sales value. Extraordinary increase in revenues with no supporting documents like GST filings, cash transactions or audit trail.
• Cash generation from non-recurring income, such as gains from asset sales, to cover operational losses along with a decline in cash sales and abnormal levels of accruals.
• Overstated or understated expenses (capitalization of revenue expenses in an unjustified manner, absence of transportation, freight, manufacturing, or repairs-to-machinery expenses in a manufacturing concern), unjustified decrease in R&D or warranty costs, shifting of future expenses to an earlier period, delaying the recording of expenses, and failure to recognize obsolete inventories as an expense.
• Fictitious purchases and sales transactions that are routed through circuitous transactions without actual movement of goods with controlled or connected entities.
• Clubbing of inter-unit sales with revenue from operations to inflate revenues which is in contravention of Ind AS 115 – Revenue from contracts with customers.
• Outstanding amounts for more than 3 years and non-provisioning for expected losses.
• Revenue booked toward the period end, followed by revenue reversals at the beginning of the period.
• Unexplained or unapproved high discounts, especially towards the end of the period.
• Under-reported cost overruns in real estate projects.

Statement of Cash Flow

Anomalies to be detected:

• Persistent cash flow problems, even when the organisation has regularly reported profits.
• Increasing earnings or profitability and consistent negative operating cash flows.
• Unexplained non-cash items that result in inflated reported performance, including shifting of financing cash inflows to operating cash inflows.
• Misclassifying normal operating cash outflows as investing activities to reduce cash outflows from operating activities.
• Excessive cash transactions.
• Diversion/siphoning off of initial public offer (IPO) funds or loan proceeds for purposes other than mentioned in the prospectus (e.g., personal expenses of the promoter, transfer of funds to promoters’ close relatives) without any supporting documentation or explanations, and channelling funds through a web of shell companies, some of which are linked through common addresses, directors, or email addresses.

Statement of Changes in Equity

Potential risk indicators are:

• Sudden and unexplained changes in promoters’ equity holding, significant increases in ordinary share capital, or changes in shareholding patterns.
• The reclassification of reserves and retained earnings along with an unrealistic share buyback.
• Stake sale or pledge of shares by promoter(s) without any clarification or not infusing money back into the business.
• Reduction in promoters’ shareholding, timed with promotional press releases about company’s growth and expansion announcements, which did not materialize, and with a corresponding increase in public shareholding.

Notes Forming Part of Financial Statements

Suspicious fraud signals:

• The mention of contingent liabilities like pending lawsuits, loan guarantees or loan covenants, misrepresentation or inadequate disclosure of accounting estimates or changes in accounting policies (e.g., inventory valuation, depreciation methods) in the notes to financial statements.
• Disclosures not made in the right spirit and letter of Ind AS.
• Ambiguous explanations of revenue recognition methods or asset valuations.
• Non-disclosure of material subsidiaries and related party transactions (RPT) is a non-compliance of Ind AS 24 – Related Party Disclosures, including no prior approval for RPT from Audit Committee, or excessive RPTs.
• Non-disclosures of material information like outstanding balances or investments in defaulting companies.
• Incorrect classification of a subsidiary as an associate leading to inflated profits in the consolidated financial statements.

Management Discussion & Analysis (MD&A)

Cautionary red flags:

• Overly optimistic financial forecasts or justifications for poor performance.
• Misleading explanations of operational success.
• Concealed financial difficulties or non-disclosure of disputes with creditors or banks (e.g., liquidity crisis, inability to meet debt obligations).
• Misrepresentation of industry conditions by projecting unrealistic growth rates.
• The exaggeration of positive news to minimize negative news, and the company’s information presented in a more subjective manner that uses persuasive language, words, appealing visuals, pleasantness, and inclusive terms (like, “we” or “our team”) to obfuscate the negative financial performance of the firm rather than providing factual financial figures.

Compliance Report on Corporate Governance

Red flags:

• Ineffective board oversight.
• A large board where the Chief Executive appoints related parties as external directors, over-aged directors, or directors of other companies.
• Any past record of non-compliance, breach of regulations, violations of other laws, or fraud allegations against senior management.
• Unusual, frequent, and mass exits of senior leaders, legal representatives, board members or top executives.
• False claims regarding credit ratings.
• Misleading project status, false claims regarding regulatory approvals in real estate business, and deceptive assurances to buyers.
• Any violations of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, such as the non-constitution of the audit committee, inconsistent disclosure of shareholding pattern, or non-disclosure of impact of foreign regulations on the business.

The users can detect plausible fraud in balance sheet, statement of profit and loss, and cash flow statement by the usage of quantitative horizontal analysis to examine the proportion of individual line items to a basic figure such as revenues, vertical analysis to compare items in the profit and loss statement and balance sheet over different time periods to detect unusual fluctuations, and ratio analysis to identify trends and inconsistencies. The Beneish M-score can be used to detect manipulative practices by using data from at least two financial reporting periods of a company. They can also use various data mining techniques that include logistic regression, decision tree, support vector machine, artificial neural network, and Naive Bayes for fraud prediction. The MD&A and corporate governance report can be analysed through text analysis method and machine learning algorithm. Sentiment analysis can be used to detect the attitudes of the company’s insiders about the future prospects of the company through their published interviews and speeches.

Implications

This verse states that all stakeholders should fulfil their duties in a responsible manner, ensuring that everyone is inclined to work towards the attainment of the goals in a fair and just manner. As a result, fraud will not be committed. In their endeavour for investor awareness and protection, following are the implications for regulators, auditors, management, investors, lenders and academicians.

Regulators

• Publish the classification of red flags on their website to educate naïve investors to equip them to detect such indicators.
• Ensure compliance with regulations by the responsible parties in preparation of financial statements.
• Ensure pre-listing forensic accounting for companies coming up with IPOs, and implement real-time monitoring of fund usage, linked to GSTN and banking networks, designed to verify that IPO proceeds are utilized in line with disclosures.
• Emphasize on usage of AI-based post-listing surveillance tools to detect financial and governance anomalies.

Management

• Understand the motivations and design robust policies to mitigate undue pressures on managers to meet internal and external earnings forecasts.
• Implement anti-fraud control measures.
• Strengthen the whistle-blowing mechanism within the organization.

Auditors and Forensic Accountants

• Tailor their standard operating procedures to focus on areas that are fraud-prone and improve their fraud detection efficiency.
• Internal auditors should report instances of undue internal pressures to meet unrealistic financial targets to the audit committee and verify the actual financial health and performance prior to payment of hefty bonuses.
• External auditors should pay special attention towards compliance with Ind AS issued by ICAI from time to time in the preparation of financial statements and reporting. Any non-compliance with Ind AS should be reported in the Independent Auditors’ Report.
• The auditors can detect the FSF in an organization by account reconciliation and document examination. A comparison of sales and purchases of the company should be made with the corresponding purchases and sales shown in the books of suppliers and customers to identify any bogus sales, purchases, and transactions. The auditors should check and verify the lorry receipts, vehicle numbers, TIN/GSTIN of vendors and customers, weighment slips, quotations, comparative quotations, and purchase and sales orders.

Shareholders and Lenders

• Empower themselves with the knowledge of red flags that are easy to locate in the annual report of a company to make better investment decisions.
• Actively raise their voice in shareholders’ meetings, investors’ forums, and various social media platforms to discuss the red flags identified by them.
• Short-term and long-term lenders should demand clarification and justification from the management regarding red flags identified by them.

Academicians

• Use this classification of red flags to train students and professionals in forensic accounting and investigation programs.
• Use fraudulent financial statements of a company as a case study and adopt a teaching-learning methodology to help the students identify red flags in various sections of financial statements.
• Include an ethics course and simulation exercise in the course curricula to make students face realistic ethical dilemmas.

Conclusion

While understanding the motivations behind misstating financial statements can go a long way as a proactive measure, the identification of red flags by the users of financial statements can help in spreading awareness about fraudulent financial statements and also act as a reactive measure to prevent and report about the possibility of fraud, thereby reducing its consequences.