Accounting Warning Signs

Management’s choices to achieve desired financial results often leave discernible evidence akin to tracks in sand or snow. The warning signs of potential information manipulation in financial reports are directly tied to the fundamental methods of manipulation: biased revenue recognition and biased expense recognition. These biases can manifest in the timing or the location of recognition.

An example of time-related manipulation is expense capitalization, which decreases the expenses of the current period and distributes the cost over several upcoming periods. Location-related manipulations could be made by misallocating losses, i.e., deducting them from other comprehensive income or even directly from equity rather than net income.

Pay Attention to Revenue

Revenue is the largest figure on the income statement and is often manipulated or subject to fraud. Simply checking if revenue is higher or lower than the previous period is not enough. Several analytical procedures can help identify potential red flags:

• Review Revenue Recognition Policies: Check the accounting policies note for details on how the company recognizes revenue. Policies that allow for premature revenue recognition, such as recognizing revenue upon shipment or using bill-and-hold arrangements, warrant scrutiny.
• Watch for Barter Transactions: These can be difficult to value accurately.
• Evaluate Rebate Programs: These involve many estimates, including forecasted rebates, which can significantly impact revenue recognition.
• Check Multiple-Deliverable Arrangements: Ensure clarity on how and when revenue is recognized for each component delivered. Even if these practices do not violate accounting standards, they require significant judgment and should be closely examined if other warning signs are present.
• Compare Revenue Growth: Evaluate the company’s revenue growth against its competitors or industry peers. If the company’s growth is out of line, investigate the reasons. It might indicate superior management or products, but revenue quality could be suspect, necessitating further analysis.
• Compare Accounts Receivable to Revenue: Over several years, check if receivables are increasing as a percentage of total revenue. This might indicate channel-stuffing or fictitious sales. Calculate the receivables turnover ratio for several years to spot unusual changes and seek explanations if needed. Moreover, compare the company’s days sales outstanding (DSO) or receivables turnover with competitors or industry peers. Significant increases in DSO or decreases in turnover could suggest premature or fictitious revenues or insufficient allowances for doubtful accounts.
• Examine Asset Turnover: If a company’s revenue generation is insufficient to justify its asset investments, particularly post-acquisition, it may indicate poor asset allocation. This could lead to accounting abuses. Calculate revenue productivity, which is revenues divided by total assets, indicates how well assets generate revenue. Declining asset turnover or lagging behind competitors might suggest future asset write-downs, especially in goodwill for acquisitive companies.

These steps help ensure that revenue figures are reliable and reflect true economic performance.

Pay Attention to Inventory Signals

While not every company has inventory as part of its asset base, those that do present the potential for accounting manipulation.

• Examine Inventory Relationships: Inventory is directly tied to revenue, so scrutinizing inventory involves similar steps as revenue analysis.
• Compare Inventory Growth: Evaluate inventory growth against competitors and industry benchmarks. Disproportionate inventory growth without corresponding sales growth could indicate poor inventory management or potential obsolescence issues that haven’t been marked down, leading to overstated profits.
• Calculate Inventory Turnover Ratio: This ratio, which is the cost of sales divided by the average ending inventory, can reveal obsolescence problems if it declines. A lower turnover ratio suggests that inventory might not be selling as quickly, potentially indicating unsellable stock.
• Consider LIFO Inventory Costing: Under US GAAP, if a company uses the Last-In, First-Out (LIFO) method in an inflationary environment, note whether older, lower-cost inventory has been used to boost current earnings, which can artificially inflate profits.

Pay Attention to Capitalization Policies and Deferred Costs

Improper capitalization can significantly misstate financial results. As such, analysts should:

• Examine Capitalization Policies: Review the company’s accounting policy note to understand its capitalization policy for long-term assets, including interest costs and its treatment of deferred costs. Compare these policies with industry standards. If a company capitalizes on certain costs while others in the industry treat them as expenses, this discrepancy raises a red flag.
• Cross-Check Metrics: For a company that capitalizes costs unusually, compare its asset turnover and profitability margins with industry peers. While higher profitability might be expected, the reliability of the reported figures may be questionable.

Pay Attention to the Relationship between Cash Flow and Net Income

While net income influences stock prices, cash flow is essential for covering expenses. Management may manipulate either, but ultimately, net income must translate into cash for the company to remain sustainable. A discrepancy where net income exceeds cash provided by operations could indicate that current expenses are being deferred through aggressive accrual accounting policies. Increasing earnings alongside declining cash from operations may be a warning of accounting issues.

As such, an analyst should create a time series comparing cash generated by operations to net income. If this ratio is consistently below 1.0 or shows a declining trend, it may suggest issues with the company’s accrual accounts.

Other Potential Warning Signs

Several indicators may suggest the need for further analysis in assessing a company’s financial health:

• Depreciation Methods and Useful Lives: The selection of depreciation methods and the estimation of useful lives can significantly impact profitability. Compare a company’s policies with those of its peers to see if they are particularly lenient, affecting earnings. Also, compare the depreciable lives used by a company with those used by its competitors.
• Fourth-Quarter Surprises: Be wary if a company routinely disappoints with poor earnings or exceeds expectations in the fourth quarter, especially when no seasonality exists in the business. This pattern may indicate over- or under-reporting profits in the first three quarters.
• Related-Party Transactions: Related-party transactions often occur when a company’s founders are still actively managing it, with their wealth closely tied to the company’s fortunes. These individuals might have a biased view of the company’s performance and may conduct business in ways that might not be detected, such as purchasing unsellable inventory to avoid markdowns.
• Non-Operating Income or One-Time Sales Included in Revenue: To disguise weakening revenue growth or enhance revenue figures, a company might classify non-operating income as revenues or fail to clarify the nature of revenues. For instance, Sunbeam Corporation in 1997 included the one-time disposal of product lines in its sales without indicating the non-recurring nature of these sales, giving a false impression of sustainable revenue generation.
• Classification of Expenses as “Non-Recurring”: Managers might classify expenses as “special items” to make operating performance appear more attractive. When these items appear regularly, investors should be cautious and focus on net income over long periods.
• Gross/Operating Margins Out of Line with Competitors or Industry: A significant disparity might signal superior management or accounting manipulations. Investors should evaluate other warning signals to determine the true cause.

Evaluate Company Culture

A company’s culture is an intangible factor that investors should consider when evaluating financial statements for potential accounting manipulation. While a highly competitive mentality in management can be beneficial for business operations, it should not extend to communications with shareholders. Such a mindset can lead to accounting manipulations, as seen in early 21st-century corporate scandals. Investors should assess whether this mentality influences the preparation of financial statements.

Research suggests that a predisposition to earnings manipulation may be more likely when the CEO and board chair positions are held by the same person or when the audit committee lacks financial reporting sophistication and independence. The current financial reporting environment should ideally penalize CEOs who endorse using financial reporting discretion to artificially smooth earnings.

Analyze Restructuring or Impairment Charges

Sometimes, a company’s stock price rises after it announces a significant restructuring or impairment charge. The conventional wisdom is that this signals management’s readiness to discard underperforming segments and focus on more profitable activities. However, analysts should recognize that the events leading to such charges did not occur overnight.

Restructuring or impairment charges indicate that prior years’ expenses were likely understated, even if no improper financial manipulation occurred. To accurately extrapolate historical earnings trends, analysts should consider making pro forma adjustments to prior years’ earnings to reflect a fair allocation of the latest restructuring and impairment charges.

Check whether Management Has a Merger and Acquisition Orientation

Analysts should need to scrutinize companies with aggressive acquisition strategies rigorously. For instance, Tyco International Ltd. acquired over 700 companies from 1996 to 2002. A growth-at-any-cost corporate culture, even with the best intentions, poses severe challenges to operational and financial reporting controls. In Tyco’s case, the SEC found that it consistently understated assets acquired, hence lowering future depreciation and amortization charges and overstated liabilities assumed, avoiding expense recognition and potentially increasing future earnings.

In conclusion, warning signals should be evaluated collectively, not in isolation. The presence of multiple warning signs should prompt investors to approach the investee company with caution or consider alternative investments

Question 1

If a company’s revenue increases faster than the industry growth rate, even though the product quality has been decreasing and the product price has been increasing relative to the competitors’ product prices, which of the following should an analyst most likely examine?

1. The trend of change in accounts receivable.
2. The companys’ revenue recognition policies.
3. Both the trend of change in accounts receivable and the company’s revenue recognition policies.

Solution

The correct answer is C.

An increasing trend of accounts receivable could indicate that a company might be lowering its credit issuance restrictions to generate more sales. Unfortunately, this could affect the uncollectible debt ratio and result in low earnings quality. Still, the company could also be involved in channel stuffing, making its revenues seem inflated.

Question 2

Which of the following most likely indicates that a company is taking advantage of accrual accounting policies to shift current expenses to later periods?

1. The ratio of cash flow from operations to net income is consistently > 1.
2. The ratio of cash flow from operations to net income is consistently = 1.
3. The ratio of cash flow from operations to net income is consistently < 1.

Solution

The correct answer is C.

A consistently less than one ratio signals that a company may use aggressive accounting policies to shift current expenses to later periods to make its current financial position attractive.

A and B are incorrect. They would not signal any accounting manipulation.