Financial Statement Fraud : Red Flag indicators

Some of the typical signs of financial statement fraud include dealings with affiliated parties, cash flows that differ from EBITDA, significant increases in certain financial statement items without proper explanation, switching auditors, departures of top executives, and excessive dependence on management assertions.

Financial statement fraud is a shadowy and insidious act that can have far-reaching consequences. Behind the veil of seemingly innocuous numbers and reports lies a hidden world of manipulation and deceit, where the truth is distorted for personal gain. It is a crime that can cause significant harm to organizations, investors, and the economy as a whole. To uncover this mystery and protect against its devastating effects, it is important to be aware of its warning signs and take proactive measures to prevent it.

There are many red flag indicators of financial statement fraud. But in this article, I will talk about those indicators which I have seen the most in the cases which I have investigated. Please note that these red flag indicators are something that you can sport from the financial statement. You don't have to go review the books of accounts of the company.

1. Cash flows from operations vs Earning before Interest Tax and Depreciation (EBITDA): "Cash is indeed the king" is a popular phrase in the business world, used to emphasize the importance of having a strong cash position in a company. A company resorting to window dressing would inflate its revenue and profits. However, if a company's cash flow from operations is consistently negative or lagging, it raises concerns as to the validity of the company's financial reporting. After all, what's the use of making sales if they don't result in actual cash inflows for the company? If you observe that cash flow from operations is persistently negative or lagging, it's a warning sign that the company might be resorting to inflating its revenue.

2. Unusual increase in sale/purchase to/from related parties: Related-party transactions can often be a murky area in the business world, as they can be used to create a misleading impression of a company's financial health. To avoid disclosure of these transactions, companies may enter into them with undisclosed related parties. Examples of such parties could include a company owned by a director's spouse or family member that conducts business with the company, or a company that has a close relationship with another company owned by a close friend or associate of a director. As an investor, it is important to keep an eye on related-party transaction disclosures in the financial statements, as transactions that exceed reasonable limits (generally around 10%) should raise red flags. For investigators, it may be necessary to delve deeper into the past directorships of key management personnel to identify any undisclosed related parties.

3. Unusual increase/decrease of certain line items of financial statements: Horizontal analysis, also known as trend analysis, is a technique used to evaluate the changes in financial data over a period of time. This analysis compares financial data from two or more different periods, typically years, and calculates the percentage change in each financial item. You can watch out for the following red flags during horizontal analysis:

   • Growth rate of sales is disproportionate to the growth rate of Cost of Goods Sold (COGS)

   • Growth rate of General and administrative expenses does not commensurate with the growth rate of sales/COGS

   • A significant increase in sales accompanied by an equally large increase in accounts receivable may suggest the recording of fictitious revenue.

   • An unexplained increase in property and equipment could also indicate improper expense capitalization.

4. Change of Auditor: A change in the auditor can be a red flag for investors and stakeholders in a company. An auditor change can indicate a variety of issues, including disagreements between the company and the auditor, dissatisfaction with the quality of the auditor's work, or a desire to switch to a different auditor who may be more lenient. In some cases, a change in auditor can also signal that the previous auditor found irregularities in the financial statements, or that the company is trying to hide potential financial problems from its stakeholders. It is important for investors to carefully review the reason for an auditor change and assess its potential impact on the company's financial health. Additionally, an auditor change may indicate a need for additional due diligence and research before making any investment decisions.

5. Resignations of top executives: The resignation of top executives of a company can be a red flag for investors and stakeholders. The departure of key individuals from a company can indicate various problems, such as disputes with management, a lack of confidence in the company's direction, or personal reasons for leaving. In some cases, the departure of top executives may also signal deeper issues within the company, such as financial problems, operational difficulties, or a decline in the company's reputation. The loss of key individuals can also impact the company's future performance, as they bring valuable experience, expertise, and relationships to the organization. As an investor, it is important to carefully review the reasons for executive departures and assess the potential impact on the company's financial health and future prospects. The resignation of top executives may indicate a need for additional due diligence and research before making any investment decisions.

6. To much reliance on the management representation by the auditor: The investors should carefully read the management representations relied upon by the auditor. A "red flag" in a management representation letter refers to a significant issue or discrepancy identified during an audit that raises concerns about the accuracy of a company's financial statements. This information may indicate potential fraud, material misstatements, or other financial irregularities that may require further investigation by the auditors. I have witnessed auditors taking advantage of management representation as a way out. For example, there have been instances where auditors have raised going concern issues regarding the company, but do not qualify their report, instead, they only state that despite these issues the management is optimistic about improving its cash flow in the future.

The aforementioned list is not a complete list of red flag indicators. It highlights some of the main red flags that can be found in financial statements. As an investigator, it is important to identify these indicators and conduct a more thorough investigation. Investors should avoid investing in companies with these red flags and not be complacent, thinking that the company is too big to fail or engage in unethical practices. Professional skepticism should be exercised when approaching any company. I hope this information has been useful.