Detecting frauds: How to spot red flags in corporate financial statements

Corporations worldwide struggle significantly to manage their operations, generate cash, and keep their businesses afloat, which adds to the pressure of meeting performance targets and market/stakeholder expectations. As a result, organisations may be tempted to take desperate measures, including manipulating the books of accounts to avert corporate failure.

Financial statement fraud means intentionally manipulating, misrepresenting, or altering a company's financial statements to deceive investors, creditors, regulators, or other stakeholders about the organisation's financial health. 

Though the motives to commit financial statement fraud may differ, the scheme/manipulation may fall into one or more of the following themes:

• Overstatement of revenue: One of the most common schemes of financial statement fraud involves artificially inflating or recognising revenue that does not exist. This type of manipulation affects revenue and trade receivables, which keep accumulating period-to-period due to their non-recoverability.
• Overstatement of assets: The value of a company’s assets, such as property, inventory, or investments, can be potentially inflated to make the company's financial position appear stronger. For example, a change in accounting practices, such as depreciation methods or altering assets’ useful life, can potentially increase the valuation of the assets.
• Understatement of expenses and liabilities: Understating the company’s liabilities or expenses to exaggerate its profits and overall financial position by not recording liabilities or delaying recognising expenses/costs. 
• Improper disclosure: Omitting or misrepresenting items such as complex adjustment entries, significant events, contingent liabilities, and accounting changes in the financial statements.
• Related party transactions: Related party transactions, including transactions with connected parties, may not technically fall under the definition of related parties but may not have transactions at arm’s length. This may lead to siphoning/diversion of funds from the company to other entities controlled by the promoters/management.

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How to spot red flags?

Financial statement fraud has emerged as one of the biggest risks for stakeholders, and the number of incidents is increasing alarmingly. 

Some of the effective ways to identify financial manipulations include:

Trend and ratio analysis

The horizontal analysis tracks financial performance over time (e.g., year-over-year comparisons), and vertical analysis assesses the structure of the financial statements (e.g., percentage of revenue, expenses, or assets); unusual variations can indicate areas of concern for deeper investigation. Also, analysing the ratios of the companies and comparing them with industry averages can help identify areas of concern and/or indications of potential manipulations.

Comparing cashflows with profitability

If a company reports significant profits but has weak or negative operating cash flows, it may be a sign of earnings manipulation or creative accounting techniques. It indicates that the accounting profits are not actually converted or realised through cash or cashflows. Overstatements, bogus revenue recordings, and other accounting manipulation/misrepresentation could exist.

Analysis can also be performed on the financial information of peers/competitors to understand the industry cash conversion ratio of accounting profits. So, a comparative analysis of the target entity’s cash conversion rate of accounting profit vis-à-vis the industry’s rate can also help identify red flags regarding bogus accounting or financial mismanagement.

Frequent changes in accounting policies

Frequent changes in accounting policies—methods of charging depreciation, inventory valuation, or aggressive revenue recognition policies compared to industry standards—may indicate financial manipulations. A thorough analysis of the “Notes to Accounts” along with the auditor’s report is crucial in identifying red flags pertaining to financial statement manipulations. 

Unusual transactions/adjustments

One-off or non-recurring transactions of significant value may positively impact the company’s profits. However, these transactions should raise doubts about the authenticity of the deal.

Forensic/special review

Frauds can be detected through forensic review by performing detailed substantive testing of transactions to check the authenticity and genuineness of the transactions. Another important check is to compare financial data with external data sources, such as tax filings, bank statements, vendor records and invoices, to verify the accuracy of the reported numbers.

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Key considerations: What can stakeholders do

The board of directors and senior management should set the tone at the top by establishing and implementing policies that promote transparency, ethical behaviour, and compliance with legal and regulatory requirements. They are also responsible for establishing internal financial controls, including segregation of duties and authorisation processes, to help prevent fraud and detect errors or discrepancies.

By fostering a culture of accountability, the governance structure helps mitigate the risk of financial fraud and mismanagement. One way to promote a strong ethical culture within the organisation could be to encourage employees to report suspicious activities without fear of retaliation through a whistleblower mechanism, enabling early detection of potential fraud. 

Companies should also invest in robust internal controls and segregation of duties to prevent fraudulent activities. Regular internal audits and independent external reviews conducted by certified professional companies can ensure the effectiveness of internal controls and compliance with financial reporting standards and regulations. 

In conclusion, detecting and preventing fraud in financial statements requires a multifaceted approach. By staying vigilant, embracing technological advancements, and fostering a culture of integrity, businesses can safeguard their financial statements, instil stakeholder confidence, and ensure long-term value creation and sustainability.

Himanshu Arora is a Partner and Puneet Grewal is a Director at Deloitte India.