Guide · For CAs & analysts

Fraud Risk Indicators: A Practical Guide for Auditors

How to read a financial statement for the red flags that matter — framed against the Standard on Auditing (SA) 240 and the ICAI Guidance Note on Reporting on Fraud (FAIS).

What is a fraud risk indicator?

A fraud risk indicator is an observable condition in a company's financial statements, transactions, or control environment that raises the probability of material misstatement due to fraud. Indicators are not proof of fraud — they are hypotheses an auditor or analyst is required to test before forming a conclusion. SA 240 (The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements) requires the engagement team to maintain professional skepticism throughout, and to design procedures responsive to identified fraud risks.

The ICAI's Forensic Accounting and Investigation Standards (FAIS)extend this discipline into the forensic engagement: framing a hypothesis, corroborating it with independent evidence, and reporting only what the evidence supports.

The two SA 240 fraud risk categories

Under SA 240, fraud is split into two categories that drive different indicator sets:

Fraudulent financial reporting — management overrides controls to misstate the financials (e.g., premature revenue, capitalising expenses, hiding liabilities, fictitious assets).
Misappropriation of assets — typically by employees: cash skimming, ghost vendors, payroll fraud, inventory shrinkage.

SA 240 also reminds the auditor that the presumption of fraud risk in revenue recognition applies on every engagement unless it is rebutted with documented reasoning.

The fraud triangle — why indicators cluster

Indicators tend to cluster around the three sides of the classic fraud triangle: Incentive/Pressure, Opportunity, and Rationalisation/Attitude. A single red flag rarely justifies escalation — an indicator from each side is what elevates risk meaningfully.

The core fraud risk indicators

1. Revenue & receivables

Days Sales Outstanding (DSO) rising materially faster than sales growth.
Large round-sum sales booked in the last days of the reporting period.
Significant journal entries to revenue with no supporting customer order or dispatch.
Customer concentration that materially exceeds industry norms, combined with related-party links.
Gross margin expanding while peers contract, without a credible operational reason.

2. Inventory & cost of sales

Inventory days rising while sales fall — classic obsolescence/overstatement signal.
Negative inventory balances or unexplained inventory write-backs.
Physical count variances repeatedly adjusted through journal entries.

3. Cash & operating cash flow divergence

Reported PAT growing while operating cash flow is flat or negative for multiple periods.
Repeated reclassifications between operating and financing cash flows.
Unexplained restricted-cash balances or "cash equivalents" held with non-scheduled banks.

4. Capitalisation & intangibles

Sharp jump in capitalised expenditure or capital work-in-progress without commensurate asset additions.
Goodwill that survives sustained underperformance of the underlying CGU.
Large prepaid expense or "other current asset" balances with no clear maturity.

5. Related parties & off-balance-sheet

Material related-party transactions on non-arm's-length terms, especially circular flows.
Loans and advances to related parties without a stated business purpose or repayment schedule.
Corporate guarantees and contingent liabilities disclosed late or only in notes.

6. Governance & control environment

Frequent auditor or CFO changes; resignations citing "personal reasons".
Dominant promoter without independent challenge on the board.
Disabled or weak segregation of duties in ERP — especially around journal entries.
Adverse remarks in the CARO 2020 report (clauses on loans, deposits, defaults, statutory dues).

7. Schedule III analytics signals

MCA's Schedule III, Division II now requires explanation of any ratio movement greater than 25% year-on-year, plus disclosure of the 11 mandatory ratios. Unexplained or boilerplate explanations of large ratio swings are themselves a fraud risk indicator — they are visible to every reader of the audited accounts.

How to test an indicator (SA 240 → FAIS)

Frame the hypothesis precisely — what specific assertion is at risk?
Identify corroborating evidence — independent, third-party, and contemporaneous.
Design a responsive procedure — confirmation, cut-off testing, journal entry testing, data analytics.
Document the conclusion — whether the hypothesis is rebutted, unresolved, or substantiated.
Communicate — escalate to Those Charged With Governance (TCWG) where SA 240 / ICAI FAIS require.

The Intelligent Financial Analyser is built around this discipline: every flagged indicator is framed as a hypothesis, paired with a suggested procedure, and never asserted as fact.

From red flag to engagement decision

A single indicator is a prompt to look closer. Two or three correlated indicators — especially when one comes from outside the financials (governance, regulatory, media) — should change the audit plan. SA 240 explicitly permits the auditor to modify the nature, timing, and extent of procedures in response to identified risks.

Run this against a real statement

Upload a financial statement to the Intelligent Financial Analyser and the workbench will compute all 41 ratios, run the 25% YoY Schedule III check, and surface the fraud-risk hypotheses described above — framed for your professional review.

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