Financial Reporting Problems and Warning Signs

FINANCIAL STATEMENT ITEM	REPORTING PROBLEM	WARNING SIGN	ANALYTICAL TOOL
Revenue	Overstated revenue.	Large increases in accounts receivable.	Look for increases in days sales outstanding (DSO) as this may indicate questionable credit sales by the company.
Revenue	Misclassification of non-operating or non-recurring revenue as operating revenue.	The company changes items included in calculation of earnings.
Expenses	Understating expenses.	Changing depreciation method; increasing useful life or salvage values.	Analyze depreciation ratios; review footnotes to see if changes have been made to company's methodology.
Expenses	Improper capitalization of items that should be expensed (done to defer expenses).	Peculiar growth in non-current assets.	Compare growth of sales to growth of non-current assets. If sales growth is low, but non-current asset growth is abnormally high, future performance may be poor.
Expenses	Classifying operating expenses as non-recurring or non-operating.	Growth in operating margin accompanied by a growth in non-recurring or non-operating items.	Monitor company operating margin trends and trends in non-operating expenses.
Liabilities	Off balance sheet financing.	Significant amount of operating leases.	Monitor operating lease trends in financial statement footnotes and add operating leases to the company's reported balance sheet.
Goodwill	Avoiding goodwill impairment.	Maintaining a goodwill balance on the balance sheet when the stock's market capitalization exceeds the book value of equity.	Monitor trends in goodwill, especially during periods of economic contraction (recession).
Cash Flows	Cash flow statement excludes non-cash investing and non-cash financing activities, as cash flow based aggregate accruals will exclude these items.	Company regularly acquires assets with stock instead of cash purchasing.	Study both the balance sheet method and cash flow method of aggregate accruals.

FINANCIAL STATEMENT ITEM

REPORTING PROBLEM

WARNING SIGN

ANALYTICAL TOOL

Revenue

Overstated revenue.

Large increases in accounts receivable.

Look for increases in days sales outstanding (DSO) as this may indicate questionable credit sales by the company.

Revenue

Misclassification of non-operating or non-recurring revenue as operating revenue.

The company changes items included in calculation of earnings.

Expenses

Understating expenses.

Changing depreciation method; increasing useful life or salvage values.

Analyze depreciation ratios; review footnotes to see if changes have been made to company's methodology.

Expenses

Improper capitalization of items that should be expensed (done to defer expenses).

Peculiar growth in non-current assets.

Compare growth of sales to growth of non-current assets. If sales growth is low, but non-current asset growth is abnormally high, future performance may be poor.

Expenses

Classifying operating expenses as non-recurring or non-operating.

Growth in operating margin accompanied by a growth in non-recurring or non-operating items.

Monitor company operating margin trends and trends in non-operating expenses.

Liabilities

Off balance sheet financing.

Significant amount of operating leases.

Monitor operating lease trends in financial statement footnotes and add operating leases to the company's reported balance sheet.

Goodwill

Avoiding goodwill impairment.

Maintaining a goodwill balance on the balance sheet when the stock's market capitalization exceeds the book value of equity.

Monitor trends in goodwill, especially during periods of economic contraction (recession).

Cash Flows

Cash flow statement excludes non-cash investing and non-cash financing activities, as cash flow based aggregate accruals will exclude these items.

Company regularly acquires assets with stock instead of cash purchasing.

Study both the balance sheet method and cash flow method of aggregate accruals.