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Red flags for possible financial fakery

Posted by L. C. Chong on January 30, 2014

I gathered the following red flags for possible financial fakery. Is there any other red flag we can add on?

  1. 1. Growth in revenues out of sync with economy, industry or peers companies, and with growth in A/R
    • Bill and hold sales – invoicing a sale without shipping merchandise
    • Sales type leases – Lessor reporting leases as a sale, particularly when the lessee is treating the transaction as an operating lease
    • Recording revenue at the time a contract is sign
  2. Aggressive revenue recognition
    • Bill and hold sales – invoicing a sale without shipping merchandise
    • Sales type leases – Lessor reporting leases as a sale, particularly when the lessee is treating the transaction as an operating lease
    • Recording revenue at the time a contract is signed, but before delivery of goods or services.
    • Recording revenue prior to fulfilling all of the terms of contracts
    • The use of swaps or barter arrangements to generate sales
  3. Loosen customers’ credit terms, which induces them to buy more products or services
    • The trick here is that even though the company has recorded a sale – which increases revenues – the customer has not yet paid for the product. If enough customers don’t pay-and those looser credit terms are probably attracting financially shakier customers-the pumped-up growth rate will eventually come back to bite the company in the form of a nasty write-down or charge against earnings.
  4. A/R increases much faster than booking sales
    • You should track how fast A/R are increasing relative to sales-the two should roughly track each other. But if sales increase by; for example, 15%, while A/R increases 25%, the company is booking sales faster than it’s receiving cash from its customers. (Remember, A/R measures goods that are sold, but not yet paid for.) As a general rule, it’s simply not possible for A/R to increase faster than sales for a long time-the company is paying out more money (as finished goods) than it’s taking in (through cash payments).
  5. The "allowance for doubtful accounts" out of line with A/R
    • On the credit front, watch the "allowance for doubtful accounts," which is essentially the company’s estimate of how much money it won’t be able to collect from deadbeat customers. If this amount doesn’t move up in sync with A/R, the company may be artificially boosting its results by being overly optimistic about how many of its new customers will pay their bills.
  6. Classification of non-operating or non-recurring income as revenue
  7. Operating cash flow out of line with reported earnings.
    • If a company is reporting positive and perhaps growing earnings, but cash flow is negative or declining this could indicate accounting irregularities
  8. Growth in inventory out of line with sales growth or days inventory increasing over time.
    • This could indicate problems with inventory management, potentially obsolete inventory or, in some cases inappropriate overstatement of inventory to increase gross and net profits
  9. Understatement of inventory vs. Accounts Payable
    • Most accounts payable transactions are for the purchase of inventory. Therefore changes in accounts payable should closely track changes in inventory. An understatement of accounts payable can be linked to an understatement of cost of goods sold and an overstatement of net income.
  10. Deferral Asset Accounts
    • The sudden appearance of a deferred asset account or a sharp increase in such an account (deferred costs, deferred expenses, deferred charges, deferred R&D).
    • The accounting policies may indicate that current expenditures are being capitalized and deferred to future years (through amortization or some other means).
    • When expenses are capitalized, the asset base of the company gets larger while itsoperating income gets a boost at the same time. This butters up a company’s income statement and makes its profits look better than it actually is. Therefore, management who pursues aggressive accounting methods might want to deem more expenses to be part of the company’s capital expenditure program as compared to more conservative peers.
    • It is important to identify if this is a common industry practice or whether the company is boosting current period profits.
  11. Classification of expenses or losses as extraordinary or non-recurring.
    • This practice makes the historical financials muddier because every charge has a long explanation and usually has various components that affect different accounts – all of which need to be adjusted if you want to look at comparable year-to-year financial results.
    • Frequent charges are an open invitation to accounting hanky-panky because firms can bury bad decisions in a single restructuring charge. Usually, the rationale for a charge is pretty vague, which means there’s a fair amount of leeway of management.
    • When a firm takes a big restructuring charge, it’s essentially improving future results by pulling future expenses into the present. In other words, poor decisions that might need to be paid for in future quarters-an unsuccessful product that may need to be terminated or a bloated division that will need to pay severance payments to redundant employees-all get rolled into a single one-time charge in the current quarter, which improves future results.
    • If you run across a firm that has frequent restructuring charges, don’t ignore them, despite the firm’s blandishments about what earnings would be after excluding the charge. After all, if a firm dug itself into a deep enough hole that it needs quarter after quarter of charges to make things right, those charges are a normal cost of improving the business.
  12. Excessive use of operating leases by lessees.
    • While there are legitimate reasons for leasing and this does not violate accounting standards, some companies structure equipment acquisitions in the form of operating leases to achieve desirable financial ratios (low debt ratios, higher return on assets). If a company is using these to a greater extend than peers, this is a potential warning sign.
    • These operating leases, despite not being recorded as liabilities on the balance sheet, would still require a company to make regular (sometimes obligatory) payments for use of whatever property and equipment that’s classified under an operating lease.
    • Airline companies, for example, have been infamous for having large operating leases as they try to keep large costs involved with the acquisition of expensive airplanes off their balance sheet.
  13. Gross margins or operating margins out of line with peer companies.
    • While indicative of good management and cost control, it can also indicate accounting methods are being selected to improve financials relative to peers.
  14. Use of long useful lives for depreciation and amortization
    • One item that can be altered is a firm’s depreciation expense. If a firm is assuming that an asset-such as a building or factory-will wear out in 10 years, it subtracts (or depreciates) one-tenth of the building’s value from its earnings each year. As you can imagine, the longer the depreciation period, the smaller the annual hit to earnings. Therefore, if a firm suddenly decides that an asset has a longer useful life and stretches out the depreciation period, it’s essentially pushing costs out into the future and inflating current earnings.
  15. Equity method of accounting
    • An accounting technique used by firms to assess the profits earned by their investments in other companies. The firm reports the income earned on the investment on its income statement and the reported value is based on the firm’s share of the company assets. The reported profit is proportional to the size of the equity investment. This is the standard technique used when one company has significant influence over another.
  16. Special purpose entities
    • A special purpose entity (SPE; or, in Europe and India, special purpose vehicle/SPV, or, in some cases in each EU jurisdiction – FVC financial vehicle corporation) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfil narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk. They are also commonly used to hide debt (inflating profits), hide ownership, and obscure relationships between different entities which are in fact related to each other (see Enron).
  17. Off balance sheet financing/guarantees
    • A form of financing in which large capital expenditures are kept off of a company’s balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.
  18. Related party transactions
    • A business deal or arrangement between two parties who are joined by a special relationship prior to the deal. For example, a business transaction between a major shareholder and the corporation, such as a contract for the shareholder’s company to perform renovations to the corporation’s offices, would be deemed a related-party transaction.
  19. Make numerous acquisitions
  20. The CFO leaves the company when there are suspicion for accounting issues
    • If you see a CFO leave a company that’s already under suspicion for accounting issues, you should think very hard about whether there might be more going on than meets the eye. The same applies to corporate auditors. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out. This one may not be a big deal by itself, but it’s definitely something to watch with firms that have already displayed other warning signs.
  21. The company frequently changes or fires its auditors after some potentially damaging accounting issue has come to light
  22. Corp tax may be payable from the results but not supported by cash flow
  23. Does the company overuse "one-time" charges or write-offs? In public announcements, does it consistently disregard GAAP earnings and point to pro forma numbers (i.e., figures "excluding charges…")?
  24. Has the company recently restated earnings for any reason other than compliance with an accounting rule change? Has the company had an unexplained delay in making regulatory filings or reporting quarterly results?
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2 Responses to “Red flags for possible financial fakery”

  1. HC Tan said

    The problem with such tricks have implictions:
    1 Corp tax may be payable from the results but not supported by cashflow
    2.Bonuses and incentives may be payable to senior executives – per their contract.
    In both cases cash is funded by creditors and is bad news for shareholders

    Like

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