There could be situations where funds are masked or hidden. This could be done for any reason such as concealing the correct fund position, or for keeping funds aside for future misuse or embezzlement.
Such practices can also be applied to give an incorrect position takeover, mergers or other instances of recovery of defaulting borrowers. Perpetrators of fraud use the infinite number of ways to hide such funds. The most common way is to make illusionary payments or payments to fictitious parties.
The effect of such payments is to reduce the bank balance in the financial accounts, but in reality, since there is no payee there is no one to present the cheques. Consequently, the funds are there to be embezzled at a later date when the opportunity arises. What are the red flags, which can be hunted for to reveal secret reserves? There are several.
The first and most revealing method is to determine whether there are stale cheques in the system. Stale cheques are cheques issued to payees who have not presented the cheques for payment for over three months. As we all know a cheque becomes invalid three months after the date of its issue.
Such stale cheques are secret reserves if they appear in the bank reconciliation statement(BRS). BRS is a simple comparison and reconciliation statement between the balance as shown in the bank statement(bank passbook) and the cash book maintained by the entity.
All the cheques issued by the entity but not presented by the payees will appear as reconciled entries in the bank reconciliation statement. Stale cheques remain unquestionable secret reserves as long as they appear in the bank reconciliation statement. They cease to be secret reserve only after they are removed from the BRS by an appropriate accounting done in the books of accounts, which is seldom done.
The secret reserve concept can be further extended even to such unpresented cheques more than one-month-old because there is a 90% chance that these payees are non-existent or that they have not been handed over these cheques for ulterior motives. Therefore, every due diligence exercise would do well to ask for a complete list of bank accounts in use and bank statements for each of these must be examined along with the BRS for secret reserves as explained above.
A similar exercise can be done for the bank reconciliation statement for RTGS payments as well. For RTGS payment details like IFSC code are extremely critical. Hence just like stale cheques, a fraudster may insert invalid credentials i.e. wrong IFSC code, which will not allow the payments to be processed by the bank. In the manner, the payment will appear in the bank reconciliation statement as an RTGS item.
Another method of funding for secret reserves is a study of the liability to third parties. Very often perpetrators create liabilities in books without any sound basis. The intention could be to show a lesser profit or to create an incorrect liability for future encashment through accomplices at an opportune time. Red flags can be spotted by studying accounting behaviour of creditors and third parties.
Imagine if vendor, suppliers or creditors do not ask for payment of large amounts due to them as per the books of account, for months and is this possible in recessionary conditions? Unlikely. Such dormant or well-behaved creditors are illusionary. A simple scrutiny of third-party payables will clearly show those who are reluctant to ask for payments. More often than not these are not really payable.
Economics, Finance and Taxation blogs 