The Reserve Bank of India (RBI) mandated a hard-line stance on systems and processes – including compliance requirements for early warning systems. By mandating forensic audits, the RBI vide notification number RBI/DBS/2016-17/28, DBS.CO.CFMC.BC.No.1/23.04.001/2016-17 dated July 01, 2016 containing Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs, has also prescribed Early Warning Signals, that is, the list of alarming transactions for which an analytical endeavor is made so that Company Secretary acting as Corporate Compliance Manager and in consulting role, should get acquainted with the practical nuances of early warning transactions, taking active interest in governance, monitoring, and advising additional measures from a regulatory perspective also.

Stance of few of Early Warning Signals (EWS) about some wrongdoings in the Corporate which may turn out to be fraudulent:

1. Default in undisputed payment to the statutory bodies as declared in the Annual report:

Delays in payment of undisputed dues to the statutory bodies indicate two possibilities either liquidity issue or malafide to clear statutory dues. Both instances are ultimate lead the Company to prosecution and compulsory payment of penalty, interest etc with a risk at solvency.

2. Bouncing of high value cheques:

Depositing cheques as received from the customers and withdrawing from the same Bank account for expenses and payment to suppliers are the standard operating system for the Company. If the Company is enjoying CC limit from the Banker then, the Company is required to operate his account within the limits granted and specified by the Banker. If Company issues cheques in excess of its utilised CC limit or insufficient bank balance, the cheques will be bounced. If its few circumstantial incidents then there are no point of worry but if its frequent practice of the Company then the Corporate Compliance Manager and KMP must count it as alarming situation and look into the matter.

3. Frequent change in the scope of the project to be undertaken by the Company:

Poor project valuation, poor monitoring, effects of global overcapacity on prices and imports are major reasons of delay or frequent changes in the scope of project which result into the unjustifiable extension of time for the project and overrun of cost. Final project takes a shape that is very different from what was envisaged at initial appraisal stage, and as a result many of the associated aspects e.g. management competency for executing the 5revised project of different scale and complexity, may not have been assessed. Project appraisal, monitoring, and strict adherence to disclosures norms shall be helpful tool for the Professionals.

4. Foreign bills remaining outstanding with the bank for a long time and tendency for bills to remain overdue:

International Trade based money laundering schemes are difficult to detect because almost all are layered within the mass of legitimate payments flowing through the complicated web of global trade. Its techniques range from fraud to the leveraging of complex network of trade and financial transactions. Pendency of export bills realisation is more possible in case of export against confirmed orders and bills sent under collection basis only due to possibilities of unhealthy tie ups between the Exporter and Importer. Longer the age of overdue position of foreign bills, more the reasons for doubt to view it with caution.

5. Delay observed in payment of outstanding dues:

Delays in payment of outstanding dues to creditors of goods or services are contractual liability and it has been required to be mentioned in the Auditors Report, if delay happens beyond specified threshold limit. The view is that, if it is a culture of making delay in payment of all outstanding dues or it becomes circumstantial compulsion for delay. Both the conditions shall compel Company Secretary to think about the financial health and intention of the Promoters to run the show.

6. Frequent invocation of Bank Guarantee (BGs) and devolvement of Letter of Credits (LCs):

The Company has to adhere to the various master circulars and directions issued by the RBI for BG and LCs. In order to defraud the Bank, siphoning off and parking fund, related party transactions have been entered into by the Company resulting into invocation of BGs and devolvement of LCs and thereby converting non-fund based limits to fund based limit. Even known party may become supplier, comply with all terms and conditions lays down by the LC issuing Bank and then the issue relating to defective goods comes into picture which will also result into the devolvement of LCs. Since the Company Secretary might know all such “known party” of the organisation, identification of such fraud prone area is highly possible through Corporate Compliance Manager.

7. Under insured or over insured inventory:

Generally, working capital limit and credit facilities are granted by the Bank on the basis of valuation of inventory and debtors. Fake and false sales and purchase invoices without e-way bills, purchase orders mixing up stock of related party into the main inventory section, substantial increase in sales and purchase without any effect over other overheads and net profit seems alarming situation. Overvaluation of inventory is main headache of the Industry at the time of recession.

8. Invoices devoid of TAN and other details:

It is mandatory to deduct TDS, and pay to the Department before specified time period. Any invoices devoid of TAN/PAN/GST are EWS for further deep dive into the transactions. Genuineness of such financial transactions must be put under the scanner.

9. Dispute on title of collateral securities:

When the title of the collateral securities is not at the name of Company then consent of the owner of property must be obtained. Avoidance or incapacity or unwillingness to obtain consent of the owner of the property might be the reason of dispute on the title which is EWS.

10. Funds coming from other banks to liquidate the outstanding loan amount unless in normal course.

If funds comes from other banks to liquidate the outstanding loan amount in the normal course of business like takeover of loan account by another bank with competitive rate of interest, second charge in favour of another bank etc. However, if major chunk of fund comes from the unknown party’s bank account for repayment of instalment by last moment of due date then dubious eyes of Corporate Manager must be fixed over such transaction.

11. In merchanting trade, import leg not revealed to the bank:

As defined in Chapter -33 (Merchanting Trade) of DIFC guideline issued by the Union Bank of India read with RBI Circular RBI/2013-14/545A.P. (DIR Series) Circular No.115 March 28, 2014, in Indian Context, the trade is called Merchanting Trade when,

    • The supplier of goods will be resident in one foreign country
    • The buyer of goods will be resident in another foreign country
    • The merchant or the intermediary will be resident in India

Thereby, merchanting transaction is one which involves shipment of goods from one foreign country to another foreign country involving an Indian Intermediary termed as Intermediary Trade in which chances of non-disclosure/hiding of transactions are very high.

Such transactions are highly tempting and risky. It is very difficult to put Merchanting transactions under the scanning eyes. Only on the basis of in sufficient KYC, documentations and infrequent payment cycle and own experience can alarm the KMP to look into such transactions.

12. Request received from the borrower to postpone the inspection of the godown for flimsy reasons:

When the management prefers to postpone inspection by the officials of bank or any other Regulatory Body, of the godown for the flimsy reasons like non-availability of concerned staff or internal vehicle of factory, own illness, heavy work orders and productions activities, renovations, few days vacation in factory due to heavy inventory, electricity-cut in the factory area etc., then doubt must be raised for inventory and working of the factory in the mind of KMP.

13. Funding of the interest by sanctioning additional facilities:

If the Company avails of any credit facilities, loan from the Bank then the Company has to pay interest to the Bank. However, in case of failure or unviable project, siphoning off or diversion of business fund, inadequate or excess credit facilities are the dangerous acts which ultimately lead to incapacity of paying even interest amount to the Bank. When Company avails of further additional credit facilities or loan for funding of interest, it is really danger and EWS for the financial health of the Company.

14. Exclusive collateral charged to a number of lenders without NOC of existing charge holders:

In the era of new technology and MCA21, it is almost very difficult to create second charge over the property without permission of first charge holder bank even for collateral securities and properties. Yet, if promoters show such courage and create second charge without noc of first charge holder then havoc may be created later on, hence it shall be treated as EWS.

15. Concealment of certain vital documents like master agreement, insurance coverage:

As a Secretarial Auditors, we know the list of applicable licences, approvals and registrations and concerned Regulatory bodies for the Company. In case when, situations like inspection, receipt of show cause notices etc arise from any Regulatory body or Bank or FI, it becomes duty of the Company to produce all master agreement, insurance coverage etc before the said authority/body. Unwillingness or concealment of such vital documents like stock statement, book debt statement, latest unaudited financial result, franchisee agreement, purchase order book, insurance policy, factory licence approval letter, pollution control board permission, import bill, original valuation report, e-way bills etc are the parameters of detection of doubts over Company.

16. Floating front / associate companies by investing borrowed money:

To run multiple business under vertical tree of companies are requirement of the day for promoters. All the segment of the industries are not always in boom market due to which one Company may incur loss, liquidity crunch and another company of the same group may run the show with profit. In such situation, the promoters get tempted to divert fund and invest into the support of loss making Company. Or associate companies may be floated by borrowing fund from the main company only with ulterior motive of siphoning of fund. All such situation ultimately break backbone of the main company hence KMP must review it as EWS.

17. Critical issues highlighted in the stock audit report:

Submission of monthly stock statement to the Bank (in case of bank loan/ cash credit limit) is compulsory. When Independent Auditor is appointed for stock audit, and he highlights critical issues in his stock audit report then such report must be reviewed not only by way of mere material discrepancy but also from the perspective of fraudulent activities.

18. Liabilities appearing in ROC search report, not reported by the borrower in its annual report

It is advisable to compare ROC search report and secured/unsecured loan portion of the annual report before printing of Annual Report. In case there is major material discrepancy like any charge ID appeared in the Search Report but no such loan is shown in the Annual Report. The facts must be checked. There are possibility that charges id is created for cash credit limit but no such limit is utilised and hence annual report does not speak about such loan. At the same time, it might possible that the CC account has not been taken into consideration either due to oversight or malafide during the process of audit. Such error shall be analysed in both way before considering it as EWS.

19. Frequent requests for general purpose loans:

Management’s frequent request in the form of loan application to the bank even for general purpose of business is a matter of worry. It must raise question in the mind of KMPs as to why, even all credit facilities are available, yet management is frequently preferring for general purpose loans because, it will make repayment capacity, more and more weakened and lead the Company to liquidity crisis.

20. Frequent ad hoc sanctions:

Ad hoc sanctions from the Bank is required for maintain working capital cycle of the Company. Sudden bulk orders may require further ad hoc sanctions of credit facilities from the Bank. However, inefficient fund management, siphoning off fund, increase in frequency of related party transactions, escalation of project cost are also out of box reasons which compel the finance team to seek frequent ad hoc sanctions from the Bank.

21. Not routing of sales proceeds through consortium/member bank/lenders to the company:

It is prima facie condition to route all sale proceeds through consortium/member bank/lender at the time of availing of cash credit and other working capital facilities. At the time of period review and renewal of such credit facilities, Drawing Power will be judged by the Bank mainly, based on sale proceeds routed from the CC Account. However, unbilled revenue, unaccounted high sea sales, related party transactions siphoning of fund are the instances in which the promoters of the Company do not prefer to route sale proceeds through specified Bank which will lead to risk to solvency of the Company and hence must be viewed as EWS.

22. LCs issued for local trade/related party transactions without underlying trade transaction

LCs are non-fund based credit facility and guarantee for payment. In case of related party transaction and accommodation entries also, such LCs have been mis-utilised where work place and godown of both the parties are either adjoining or same. Sometimes, bank branch also seems same to minimize time of banking transaction. Possibility of actual transfer of goods and sale and purchase of goods at arms’ length price is very less. This are also few of the ways of siphoning of business fund so KMP must treat it as early warning transaction.

23. High value RTGS payment to unrelated parties:

“Unrelated parties” means such party with whom no sale-purchase transactions or agreement are executed by the Company. High value RTGS payment to unrelated or unidentified or fictitious party with illogical reasons must be termed as fraudulent transaction and reviewed in the strict purview of EWS by KMP.

24. Heavy cash withdrawal in loan accounts:

In the Digital Payment and plastic money era, necessity of cash is reduced in the business depending upon the type of industries. The organisation must avoid to withdraw cash from loan account unless until barely required to maintain the business cycle. Otherwise, it may termed differently and negatively and become point of inquiry even for Regulatory body in the event of collapse.

25. Non-production of original bills for verification upon request:

All original bills are required to be kept in the safe custody of the Company. Section 128(5) of the Companies Act, 2013 states that the books of account of every company relating to a period of not less than eight financial years immediately preceding a financial year, or where the company had been in existence for a period less than eight years, in respect of all the preceding years together with the vouchers relevant to any entry in such books of account shall be kept in good order. When the Company denies or issue flimsy reason for production of original bills for verification upon request of bank or any Regulatory body then such act must be treated as EWS.

26. Significant movements in inventory, disproportionately differing vis-a-vis change in the turnover:

All the listed Companies are required to publish & submit to Stock Exchange, financial statement as mentioned in SEBI (LODR), 2015 and all companies enjoying cash credit facilities are required to submit periodic stock statement and financial statement to the Bank. The thumb rule is to tally entire stock statement with the GST Returns. Inventory of finished goods and raw materials have direct relation with the creditors and debtors. Hence, disproportionate movement of inventory in stock statement comparing with the GST/TDS returns, figures of turnover indicate possibility of fishy circumstances in the business cycle of the Company.

27. Significant movements in receivables, disproportionately differing vis-à-vis change in the turnover and/or increase in ageing of the receivables:

It becomes necessary to know the general working capital cycle of the business segment in which the Company operates. If the age of receivables is much higher than the permissible under the same business segment, or if loans and advances from the “known party” are wrongly included in the sundry debtors/ trade receivables then, the movements in receivables must become disproportionate as comparing with the turnover of the Company which must alarm in the mind of KMP.

28. Disproportionate change in other current assets:

Current assets have tendency to convert into the cash or cash equivalent during the working capital business cycle of the Company. Such turn on and on, give breathing to the working capital cycle. However, diversion of or siphoning off fund, frequent related party transaction, wrongful accounting entries compel disproportionate change in other current assets of the Company, which is one of the EWS and disturb working capital cycle.

29. Significant increase in working capital borrowing as percentage of turnover:

It is always observed that unexpected increase in the working capital transactions without any favourable factors to the industry for increase in turnover, may create strong possibility of diverting excess fund of working capital limit to another business or self motive of KMP.

30. Increase in Fixed Assets, without corresponding increase in long term sources (when project is implemented).

It is prudent management practice to finance Fixed Assets from long term sources. In case where, fixed assets is financed from short term sources, that is to say, fixed assets will increase without corresponding increase in long term sources then it will increase chances of financial pressure and failure on the part of the management of the Company.

31. Increase in borrowings, despite huge cash and cash equivalents in the borrower’s balance sheet

If it is tendency of management to pay out old loan from the receipt of proceeds of new loan then borrowing of the Company will be increased despite of huge cash and cash equivalent in the balance sheet of the Company. Ultimately, it will disturb all ratios and financials of the Company and lead to financial crunch also. Prominent review of such EWS must be demand of the day for KMPs.

32. Frequent change in accounting period and/or accounting policies:

Change in accounting period and/or accounting policies are not fraudulent activities since it might be requirement of the Organisation with the Experts advice. However, frequent change is not advisable since it might be result into intention to show inflated earning, reserves and assets, to show eccentric pictures to investors, to avoid loss booking. Corporate Compliance Manager must treat such situation as EWS with proper review.

33. Costing of the project which is in wide variance with standard cost of installation of the project

Time factor is very important for implementation of any project. If time is overrun, project cost would be escalated in almost all the cases. Sometime, the circumstances may be not favourable and genuinely the time factor over run but many times, error in calculations and its implementations might become major reasons of wide variance with standard and actual cost of installation of project. This will not only increase uncontrollable financial burden but also increase possibility of project failure and resulting into evaporate shareholders’ fund and borrowed fund also.

34. Claims not acknowledged as debt high:

Generally, any legal claim or future liability under any pending litigations with Regulatory Body or private party has been treated as contingent liability. When the management conceal such information and do not prefer to acknowledge as debt then chances of increase in liability and liquidity crunch is very high and must be termed as EWS.

35. Substantial increase in unbilled revenue year-after-year:

It is very difficult to trace out unbilled revenue since, it mainly generates cash only. Such unbilled revenue may be the compulsion for “kick back”, “cash back” for obtaining new contract from the Government or tax evasion or like reasons. If unbilled revenue increase substantially then fear of search, inquiry etc. from Regulatory Department like Income Tax, GST will increase which ultimately disturb operations and business of the Company and hence it must be treated as EWS.

36. Large number of transactions with inter-connected companies and large outstanding from such companies:

Arms length transactions with proper compliance of the Regulations are not the matter of worry. But other than such permissible transactions of sales and purchase, loan payables and receivables are highly indicative transactions of circulations and/or diversion of business fund. Economic Rationality needs to be checked in case of large number of transactions with inter-connected companies and large outstanding from such companies.

37. Substantial related party transactions:

The Companies Act, 2013, the SEBI (LODR) Regulations, 2015, and the applicable accounting standards (AS 18 or Ind AS 24 etc.), speaks about the identification and monitoring of Related party Transactions (‘RPTs’), with disclosure requirements up to certain extent at arms’ length basis. When the Company’s management prefer to cross or smartly try to violate the provisions due to which substantial related party transactions happens, then it becomes main instance of siphoning off / diversion of business fund and EWS.

38. Material discrepancies in the annual report and significant inconsistencies within the annual report (between various sections):

The Companies Act, 2013, RBI Prudential norms issued for NBFCs, SEBI (LODR) Regulations, 2018 have prescribed timeline for submission of Annual Report in specified format. Delay in submission of annual report must be justifiable. When the Company avoids to stick to specified format of the presentation of Annual Report by way of non-disclosure of information, improper format or any error, omission, material discrepancies, significant inconsistencies found in the Annual Report then the there are reasons to believe about existence of some fishy matter which the management does not want to present before the shareholders. It must be reviewed and taken as early warning transaction.

39. Poor disclosure of materially adverse information and no qualification by the statutory auditors:

Disclosure in the Annual Report requirement is governed by Companies Accounting Standard Rules, 2006, Companies Act, 2013, SEBI (LODR), 2015, RBI Prudential norms and directions issued under the RBI as amended from time to time till date. Any deviation in terms of less disclosure, non disclosure or wrong disclosure of materially adverse information must be reviewed as EWS.

40. Raid by Income tax /GST/ TDS/central excise duty officials:

As we know, raid, search, survey, seizure are undertaken by the officials of the Income Tax/GST/TDS/ Central excise on the basis of various information, inquiry and documents. E.g., if GST department has conducted raid and tax evasion is confirmed during such raid then it becomes surely fraudulent and risky indicators for which KMP must reviewed situation with a serious note.

41. Significant reduction in the stake of promoter/director or increase in the encumbered shares of promoter/director:

The situation of reduction in the stake of promoter/director or increase in the encumbered shares of promoter/director indicate intention of promoter towards the overall business of the Company which may be exit, either by way of en-cash and dilution of stake to the open market or re-organisation of share capital by way of amalgamation or invitation to private equity in the Company or such compulsive situation. It must be counted and reviewed as EWS.

42. Resignation of the key personnel and frequent changes in the management:

All Corporate business have their own knowledgeable team, funds, strategy, policy, slogan and goal to remain competitive in the market. Promoters, Board of directors, Managers, Key managerial personnel are the backbone, symbol and identity of the Company. The famous proverb “when Ship is shrinking, rats are leaving it first” needs to analyse when frequent changes in the management of the Company happens due to resignation of KMP. Deteriorating financial health, management dispute, inefficiency of management in operation of business, continuous losses may be reasons of resignation of the KMP which is risk indicator.

Company Secretary can take help of fair and un-biased technology for good corporate governance practices.

Acknowledgement:

It is my personal views based of my experience of around 20 years in the corporate world as a Practising Company Secretary. I have gone through www.rbi.org.in while expressing my views in the aforementioned article.

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18 Comments

  1. Prabhat Kumar says:

    As a Forensic and Investigative Accountant in Practice I really appreciate the sharpness of the author to observe these signs.

  2. NILESH SHAH says:

    Very useful informative article. Nicely explained. Love this type of article to read. Tax guru thanks for sharing such a lovely article.

  3. Chandrashekhar Kelkar says:

    Knowledgeable article. In depth information. As ex banker and PCS and also may be for Independent Director found it very useful.

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