Accounting Warning Signs

Financial manipulation leaves a trail, like tracks on sand or snow. The manipulation could be time-related or location-related. An example of time-related manipulation is expense capitalization, which would decrease the expenses of the current period and distribute the cost over several upcoming periods. Location-related manipulations could be made through misallocating losses, i.e., by deducting them from other comprehensive income or even by deducting them directly from equity rather than net income.

Pay Attention to Revenue

Revenue is the most frequently manipulated financial report item. Here are ways to examine revenue quality.

• Examine the accounting policies note for a company’s revenue recognition policies: search for “bill and hold” transactions and early recognition of sales. Discern contracts with multiple deliverables to lensure that each deliverable’s revenue is matched with the recognition of the costs incurred to make that deliverable.
• Look at revenue relationships: Compare a company’s growth with its primary competitors or industry peer group. If the growth of the company’s revenues is faster than the industry/peer group, then the superior performance must be justified. Possible justifications could either be better management or/and better product/service quality.
• Compare accounts receivable with revenues over several years: A rising ratio could indicate insufficient allowance for questionable accounts or even fictitious sales.
• Examine asset turnover: It becomes crucial in the case of a new acquisition. If a company’s asset turnover is continually declining or lagging behind the asset turnover of the industry, then, this could signal possible future asset write-downs, particularly in the area of goodwill balances for acquiring companies.

Pay Attention to Signals from Inventories

• Compare growth in inventories with competitors and industry benchmarks: If a company breaks the trend, it could simply be a matter of bad inventory management or an indication of inventory obsolescence. The latter could mean that the company’ assets and profits are over-estimated.
• Calculate the inventory turnover ratio: a slowdown in the inventory turnover ratio could suggest inventory obsolescence.

Pay Attention to Capitalization Policies and Deferred Costs

Suppression of expenses is the second most frequent method of financial report manipulation.

• Examine a company’s accounting policy note for its capitalization policy for long-term assets, including interest costs and its processing of other deferred costs: if a company capitalizes costs that are expensed in most of its industry peer group, the difference should be adjusted to reflect a lower asset value and lower earnings for that company.

Pay Attention to the Relationship Between Cash Flow and Net Income

A cash flow to earnings that is consistently below one might signal heavy use of accrual accounting.

Other Potential Warnings Signs

• Depreciation methods and valuable lives: a big difference between the depreciation method and the estimated useful life of a company and its industry peers could be a sign of a manipulation attempt.
• Fourth-quarter surprises: as managers try to avoid cooking the books unless it is inevitable (from their point of view), most of the manipulation happens in the results of the fourth quarter. Therefore, an analyst should closely check companies that repeatedly achieve out-of-expectations’ consensus results in the fourth quarter, assuming that the company’s business has no seasonality.
• Presence of related-party transactions: These transactions often arise when a firm’s founders have a significant amount of their wealth tied to the company and are actively involved in the management of the company. This will lead to management becoming more biased toward company performance, motivating them to transact business with the company in undetectable ways.
• Non-operating income or one-time sales included in revenue: a company can add the sale of an asset to revenue to hide a decline in the revenue generated from its core activities. A similar scheme could decrease the company’s losses by classifying some of the company’s expenses as “non-recurring.”
• Classification of expenses as “non-recurring.” Special items are carved out of the income statements by managers to make operating performance look more attractive. Equity investors are often more focused on the net income line when evaluating performance over time and thus will not accept the carve-out serial “special items.”
• Gross/operating margins out of line with competitors or industry: This difference is an ambivalent warning sign. A gross/operating margin different from the industry often signals superior management ability. However, it could also indicate that accounting manipulation implies superior management ability.

Company Culture

An investor should consider a company’s culture when evaluating its financial statements for accounting manipulation. A firm’s highly competitive mindset and culture may serve investors well when conducting business. Still, the same culture and mindset can lead to the accounting manipulation seen in the early 2000s. In an attempt to examine the financial statements for warning signs, an analyst should not ignore the existence of such a mindset.

Restructuring or impairment changes

Company stock prices have risen after a big bath charge was recognized to reported earnings. This could be a positive signal that the company’s management is now ready to let go of lagging parts of the company to direct talent and attention to the more profitable parts. An analyst will make pro forma analytic adjustments to prior years’ earnings to extrapolate historical earnings trends, reflecting a reasonable separation of the latest periods ‘impairment and restructuring charges.

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.