Identification of Green flags in Audit of Financial Statement

CA Amrita Chattopadhyay | Last updated: 20 August 2022

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While auditors are trained to spot 'Red Flags' indicating potential fraud in financial statements, this article highlights the importance of also identifying 'Green Flags'. These are seemingly positive indicators, often described as the 'Too Good to Be True' syndrome, that can mask underlying fraudulent activities. Examples include consistently excess cash, unexpected high returns, or a company outperforming its industry during a slump.

The business environment has witnessed rapid growth in the fraud in the financial statements which is also termed as "White Collar Crime". The magnitude in which the fraud incidents have grown recently that the auditors cannot be a mute spectator and ignore the fraud risks in the financial statements. Companies Act 2013 casts responsibility on the auditor to report the fraud to the Central Government while describing the powers and duties of the auditor. The Auditing standard issued by ICAI also dedicates a specific standard SA 240 – The Auditor's responsibilities relating to fraud in an Audit of Financial Statements.

The standard guides us regarding the fraud risk factors which the auditor is expected to identify. Fraud risk factors are the events or conditions that indicate an incentive or pressure to commit fraud or provide opportunity to commit fraud. While identification of these fraud risk indicators, the indicators are generally called as the "RED FLAGS". Red flags are the circumstances which may indicate the presence of fraud. The emphasis here is to detect the anomalies and inconsistencies in the financial statement.

Green Flags in Financial Audit: Spotting Too Good to Be True

During the fraud detection in any organization, the auditors generally look for the red flags for indication and reduction of risk arising due the fraud for the white-collar crimes. These indicators could be shortages in stock, close nexus with third parties, missing documents, shortages in collections etc. On the contrary there could be other symptoms which leads to greater sense of assurance and comfort in a particular situation but which may potentially infuse with fraud. These signals could be termed as GREEN FLAGS. Green flags are in many ways converse to the red flags. They can also be termed as "Too Good to be True" syndrome. Few of the examples for the Green Flags could be:

Maintenance of excess cash without any shortage
Unexpected windfall income in certain months
Unusually high return provided by an investment
Company performing very well when the overall industry is in slump

CASE STUDY OF GREEN FLAGS

Excess cash reported by the cashier: In one of the unique cases, the cashier always showed excess cash on the cash counts, but never reported any shortage of cash
Up dation of the records: Sales and service station jobs statistically moved together in the service station and the sales outlet of a manufacturing entity.
Excessive loyalty of employee: An accountant / employee paid from his personal balances to make up for a double payment which was inadvertently approved and also paid by him
High rejection by the Quality Manager: Rejections were made by the Quality Manager which was as high as the twice the production by the sub-contractor. The sub-contractor was penalized for the rejection of the raw material. The sub-contractor almost lost quarter of his profits for rejection.
Unexpected increase of income in certain situation: A branded educational institution received unidentified cheques for conducting specialized and popular training workshops and seminars. The cheques were received which did not contain any covering letter mentioning the purpose for which the cheques were sent.
Employee making out of pocket expenses: Employee went to outstation tour for the company purpose. As per the policy of the company, the employee did not take any advance but made expenses from his personal account. The bills for the expenses incurred were sent to the company almost after two years for reimbursement.

While conducting the audit of financial statement and fraud investigation it is imperative for the auditor to focus his attention not only for the RED Flags but also to draw his attention towards the green flags in the financial statements and the operations in the organization. Ignoring the green flags in the organization and the financial statements may be detrimental and sometimes it is possible that the green flags in the present scenario may result in converting to potential red flags.

The auditor needs to maintain overall professional skepticism and an open mind during the audit.

FAQ :

Green Flags are signals or circumstances in financial statements and company operations that appear positive or reassuring but could potentially indicate fraud. They are often described as the 'Too Good to Be True' syndrome.

Red Flags are indicators that suggest the presence or possibility of fraud, such as missing documents or stock shortages. Green Flags, conversely, are positive-seeming indicators that might conceal fraud, such as consistently excess cash or unusually high investment returns.

Examples of Green Flags include maintaining excess cash without explanation, receiving unexpected windfall income, an investment providing unusually high returns, or a company performing exceptionally well while the overall industry is struggling.

Auditors must pay attention to Green Flags during financial statement audits and fraud investigations, not just Red Flags. Ignoring them can be detrimental, as Green Flags can sometimes evolve into potential Red Flags.

It's crucial because Green Flags, despite appearing positive, can mask fraudulent activities. Ignoring them could lead to undetected fraud, and they may signal future risks or problems within the organisation.