Master Class on the subject of “Early Warning Signs and Red Flags for Independent Directors”
A Master Class on the subject of “Early Warning Signs and Red Flags for Independent Directors” was organized on April 24, 2020. The Master Class aimed at orienting the Independent Directors about the early warning signs to be diagnosed and red flags to be raised on the financial statements for effective financial controls and governance mechanisms in place.
The key speaker of the master class was CA Gyan C Pipara, an expert on the subject who acts as a board advisor and author of books.
The speaker informed the participants about the means and ways to diagnose the early warning signs for raising red flags. The understanding has been emphasized to be important from the perspective of addressing it at proper forums (Board or Committee meetings) and prevent its future recurrences. He further emphasized that Independent Directors need to be extra cautious in checking the Auditor's Report and its nature. It could be a normal or a qualified report. If it is found to be a qualified report, then the previous year’s figures or reports also require due reference on their part.
The speaker introduced the participants with an important report called CARO Report. CARO stands for Company Auditor’s Report Order, which contains matters with relation to details of tangible and intangible assets, details of inventory and working capital, details of investments, any guarantee or security or advances or loans given, various compliances, etc. It was also emphasized that CARO Report should be thoroughly checked as it contains a lot of important information. In case the company does not provide the CARO Report to the Independent Directors, they should specifically ask for it. For instance, if major funds invested in fixed assets are shown as additions to it, then it should find a mention in the CARO Report. Further, the Independent Directors can satisfy themselves about the genuineness of the transaction by physically verifying the assets. Also, the title deed has to be in the name of the company otherwise it is a warning sign.
While discussing the importance of early warning signs and the red flags, Independent Directors were also explained about the concept of Related Party Transactions using suitable examples. For example, if a company is purchasing raw material from a related party and selling it to another related party, then it is an early warning sign. With regard to loans and advances, it was explained that if loans are taken from a financial institution and given to its subsidiary, then it could be a red flag as this practice is followed by many companies, which are later accused of entering into fraudulent transactions.
The discussion was further accentuated by emphasizing that “Capital Work in Progress (WIP) “has to be closely watched by Independent Directors. The reason given was that some companies show Capital WIP for 3-4 years and then suddenly declare that they have no value and has to be written off. Sometimes operating expenses are shown under Capital WIP, which is wrong. It was further elaborated that High Inventory and High Debtors is also a Red Flag that should be closely looked into. Further, if a huge investment is made in a subsidiary and the objective of the holding company is not aligned with the objective of its subsidiary then it is also a warning sign.
Moreover, the discussion was made more interesting by highlighting some other important aspects, which can act as a red flag and early warning sign. They are briefly enumerated as below:
- Subsidiaries in tax-free havens with no requirement of maintenance of books of account.
- Current liabilities are more than Current Assets.
- Huge Finance Cost.
- Weak Internal Control.
- Different Software at Head Office and Branch and manual entry of transactions is also a warning sign.
- Sales are declining but fixed assets are increasing, indicating that fixed assets are not properly utilized in the operating activities.
