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SOP FOR INVESTIGATION OF FRAUD IN CASE OF DEPOSIT TAKING COMPANIES

STANDARD OPERATING PROCEDURE (SOP) FOR INVESTIGATION OF FRAUD IN CASE OF DEPOSIT TAKING COMPANIES

India has been flooded with various Ponzi schemes that take advantage of small investors looking for alternate banking options. Lacking access to formal banks, low-income Indians often rely on informal banking. These informal banks invariably consisted of money lenders who charged interest at inflated rates and were soon replaced by more sophisticated methods of conning people through disguised Ponzi schemes.

Steps to investigate fraud in case of deposit taking companies

Analysis of Financial Statements in order to detect fraud:

  1. Vertical and horizontal financial statement analysis  introduces a straightforward approach to fraud detection.
  2. Vertical analysis involves taking every item in the income statement as a percentage of revenue and comparing the year-over-year trends that could be a potential flag cause of concern. 
  3. A similar approach can also be applied to the balance sheet, using total assets as the comparison benchmark, to monitor significant deviations from normal activity.
  4. Horizontal analysis implements a similar approach whereby rather than having an account serve as the point of reference, financial information is represented as a percentage of the base years' figures. 
  5. Likewise, unexplainable variations in percentages can serve as a red flag requiring further analysis.
  6. Comparative ratio analysis also allows analysts and auditors to spot discrepancies within the firm's financial statements. By analyzing ratios, information regarding day's sales in receivables, leverage multiples and other vital metrics can be determined and analyzed for inconsistencies.
     

Financial statement fraud

Financial statement fraud is majorly of the following types:

  1. Fictitious sales
  2. Improper expense recognition
  3. Incorrect asset valuation
  4. Hidden liabilities and
  5. Unsuitable disclosures

Step by step analysis of manipulation of individual items in financial statements:

  1. Mode of fund raising - Fund raising is done through legal activities such as collective investment schemes, non-convertible debentures and preference shares. It is also acquired illegally through hoax financial instruments such as collective investment schemes (CIS) that are disguised as tourism packages, real estate projects and the like.

 

  1. Nature of investment - The company collected money from investors by issuing redeemable bonds and secured debentures promising incredulously high profits from reasonable investments. Many investors were duped into investing in what they thought was a chit fund. This is an attempt to get SEBI off its back, as chit funds fall under the jurisdiction of the state government, not SEBI. 

 

  1. High value of brokerage fees reflecting in income statement – These companies use brokers to lure customers; local agents are hired and given huge cash payouts from investor deposits.

 

  1. Type of investors – The deposit taking companies take advantage of unsuspecting investors looking for alternate banking options. Lacking access to formal banks, low-income Indians often rely on informal banking.

 

  1. Large number of group companies – The deposit taking companies generally tend to form large number of group companies. Companies Act requires any company raising money from more than 50 investors to have a formal prospectus, and categorical permission from SEBI, the market regulator. In order to avoid this regulatory compliance, some of the deposit taking companies seek to evade prosecution by expanding the number of companies, thus creating a convoluted web of interconnected players.

 

  1. Higher sales growth as compared to industry - Consistent sales growth of the deposit taking companies while established competitors are experiencing periods of weak performance. The company maintains consistent gross profit margins while its industry is facing pricing pressure. This can potentially indicate failure to recognize expenses or aggressive revenue recognition.

 

  1. Significant surge in the company's performance - A significant surge in the company's performance during the final reporting period of fiscal year when compared to the previous months of the same year, raises an eyebrow for the investigator. The company may be under immense pressure to meet analysts' expectations at the end of the financial year.

 

  1. Reported earnings consistently higher than cash flow: If cash flow from operating activities of a company is consistently less than the reported net income, it is a warning sign. The investigator must ask                     why operating earnings are not turning into cash.
     
  2. Inflated earnings by lending to customers: Sometimes companies lend money to customers to buy their own goods. This way they report high revenue in the income statement and high receivables (treated as an asset) in the balance sheet.

 

  1. Inflated earnings by trade stuffing: Companies use this usually just before the end of a reporting period. They ship goods to customers even though the latter may not need them immediately. This increases sales just before the end of the reporting period.
     
  2. Inflated earnings by understating provisions: Companies often allow credit sales on generous terms, sometimes even to customers with a poor credit history. Ideally, in such sales, the company should set aside a higher amount for bad debt provisioning. This amount is recorded as a liability. Understating such liabilities is another way of 'enhancing' the financial statement.

 

  1. Understating expenses by spreading out expenses: According to accounting norms, if an expense has been made for acquiring an asset whose benefits the company will avail of over a long term, the expense is to be reported in the books in a spread-out manner over that period. The process is called capitalising. Companies often use this to delay recognition of short-term expenses.

 

  1. Understating expenses by cookie jar accounting: Companies put aside money for possible loan defaults. Some companies, during periods of high revenue growth, increase the amount and release the same during periods of poor revenue, offsetting the impact of low sales growth. Among other common forms of financial statement manipulation are revaluation of assets, showing unrealised gains as profits and assigning higher values to fixed assets.

 

  1. Related party/ third-party transactions: Outsized frequency of complex related-party or third-party transactions, to inflate revenue. Revenue inflow from related parties rather than by way of inflow from operating activities is considered to be fictitious.

 

  1. Spurt in other income: Revenue sources recorded under other income include earnings from asset sales and closure of debt or debt restructuring. However, sources of earnings are seldom disclosed under this head. A sudden spurt is a matter of concern.

 

  1. Frequent changes in policies: Earnings and assets can be inflated by alternative accounting policies. If one sees frequent changes in these policies, there may be something fishy about the company's books.

 

  1. Financial ratios not in line with industry peers: This could be due to inflated earnings, asset valuation or understating of expenses and liabilities.

 

  1.  Continuous high level of cash, cash equivalents and current assets: Huge amount of cash, cash equivalents and current assets also raises eyebrows since all the aforesaid assets are highly liquid assets. Sometimes these figures are inflated in order to lure investors.

 

  1. Analyze accounts receivable-Revenue manipulation, a common form of financial fraud, will often affect receivable balances. Investigation of outlier activity in receivables, basis for uncollectible accounts, and receivable statistics in comparison to industry standards can help identify potential financial reporting problems.

 

  1. Sudden increase in inventory/sales ratio: This indicates the company may be inflating assets such as inventories and receivables. A rapid and unexplainable rise in the number of day's sales in receivables in addition to growing inventories suggests obsolete goods for which the firm records fictitious future sales.

 

  1. Large amount of fixed assets - An unexpected accumulation of fixed assets can flag the usage of operating expense capitalization, rather than expense recognition.

 

  1. Depreciation and useful life - Depreciation methods and estimates of assets' useful life that do not correspond to the overall industry. An overstated life of an asset will decrease the annual depreciation expense leading to increase in profits.

 

  1.  Replacement of auditor - The auditor was replaced, resulting in a missed accounting period. Auditor replacement can signal a dysfunctional relationship while missed accounting period provides extra time to "fix" financials.

 

  1.  Management’s compensation - A disproportionate amount of managements' compensation is derived from bonuses based on short term targets. This provides incentive to commit fraud.

 

Precautions the investors need to take in order to prevent fraud by deposit taking companies:

 

  1. Check for the credibility and creditworthiness of the company and its promoters.
  2. Opt for state-run chit companies and go with firms with a long record and financially sound promoters.
  3. Understand the difference between Organised chit fund schemes which are required to register with the Registrar or Firms, Societies and Chits and money circulation schemes.
  4. Invest in a scheme with no incentives for subscribers to bring in more people to the scheme.

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