Red Flags and Accounting Warning Signs
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The United States uses the Generally Accepted Accounting Practices (GAAP) while the UK uses International Accounting Standards (IAS) to report financial statements. The quality of financial statements must reflect the actual financial status of the company, to give its shareholders an accurate view of the company. Unfortunately, several corporations fudge their accounts to over-report or in some cases under-report their financials. There are red flags and indicators that auditors and shareholders can use to spot discrepancies in financial statements.
The main motivation to over or under-report financial earnings is that companies see benefits to be accrued. Firms can over-report their earnings when they need to project that they have met earning projections to shareholders. They can also over-report if they have debt commitment benchmarks with banks and other lending institutions. In some cases top executives earn incentives based on company earnings. Here again they can inflate company earnings to receive these large bonuses.
Firms under-report their earnings if they are eligible for government grants or funding incentives if their earnings are below a certain level. They can also under-report when they do not want to share the profits with their worker unions. Sometimes they under-report to avail better terms from their creditors.
Firms tend to indulge in some storytelling in their balance sheets to carry forward a certain narrative of either high solvency or being insolvent. Both of these steps are undertaken for different benefits but are similar in the sense that they do not portray the true picture of the firm’s financial status.
Firms can misuse accounting standards to present poor financial earnings.
Aggressive accounting practices and assumptions, placing desired outcome to structure transactions and not showing the trail of transactions to actual outcomes, misrepresenting the intent of the accounting principle and providing incorrect economics of a transaction using accounting principles.
Auditors check for one or more items of the fraud triangle to check the veracity of financial statements.
The presence of weak internal controls gives the firm the opportunity to commit fraud. The motive to commit fraud may be because of pressure or incentives. A rationale that the fraud is justifiable presents itself as an attitude.
Incentives to commit fraud are threats to the firm's stability because of changed economic conditions or industry scenarios. Third-party pressure on the management, pressure to meet financial projections and net worth of the board of directors is under pressure.
Poor internal controls, unstable market conditions coupled with poor organizational structure and order, poor monitoring and the nature of the industry enables fraud.
The culture of fraud is outed by more attitudinal reasons. Usually, such firms have a strained relation with their previous auditors. They ignore compliance issues that they are aware of. Poor ethical standards and an unusual involvement of non-financial staff in the setting of accounting standards. A trail of legal and regulatory violations, under-reporting of earnings to avoid tax, and a misstatement or omission of items in the balance sheet to alter the understanding by shareholders and auditors. Rounding all of this is an intrinsically unethical attitude to doing business.
The common signs of misreporting of earnings are many. Let’s look at some salient ones.
Firms lower their revenue though deductions and expenses to fall in a lower tax bracket. Others may over-report earnings to meet earnings projections , stock option performance bonuses or meet debt agreements. Some items to check are days sales outstanding ratio, net income and cash from operations out of line, comparison of revenue with close competitors, and booking of non-recurring revenue as revenue.
Observe the difference in the operating cash flow and earnings. A company may book a profit but have poor cash flows, which indicates it does not have enough money for its operations. Good cash flows are indicative of sustained growth. The money could be locked in inventory or receivables. So to have a good indication of solvency, cash flow growth should be monitored more closely.
In some firms the inventory is higher than the sales growth. It enables reporting of skimming or bogus sales. In some cases inventory is falsified, the value of the inventory is inflated or false sales may be noted. This is why it is important to flag events where the inventory is more than the sales growth in a given period.
Another indicator of accounting fraud is abnormal comparative sales growth. The sales growth in firms tends to be organic, with either growth or decline by a few percentage points. Sudden spikes or dips in the sales growth need to be examined. For example, the Covid-19 pandemic resulted in no business for several firms. There is a clear reason for the dip. However, when there are no clear reasons it could be a sign of inflating sales with intent to misreport.
Activities that a firm undertakes outside of its core activities to generate income are called non-operating income or non-recurring income. This includes dividend income, gains or losses on investments or foreign exchange transactions. Sometimes firms use non-operating income to boost revenue. This is a fraudulent practice as it does not reveal the true income of the business. Any non-recurring items (gains or losses) must be adjusted, as they are not part of ongoing operations.
Another red flag is the delay of expense recognition. According to accounting principles, the expense incurred and revenue earned should be reported in the same period. If expense recognition is delayed without cause it indicates an attempt to boost revenue reporting. Managers usually explain this omission as an error or misstatement during the audit.
Leases, joint ventures, research are all considered off-balance sheet financing. In reporting this expenditure, earnings can be hit, so companies sometimes report this as off-balance sheet spending, so that their debt agreements are not impacted. However, if this off-balance sheet financing becomes large and the company is unable to pay it back through its cash flows, the company can become insolvent. The Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) requires balance sheet recognition of leases and note disclosure of certain information about lease arrangements, in order to minimize this type of fraud.
Firms are allowed to classify items in their statements into different categories. Firms can sometimes itemize large expenses as non-recurring or extraordinary items even though they occur on a yearly or bi-yearly basis for instance. This allows reporting of an incorrect picture of earnings to shareholders.
If a company sells more units than manufactured in a period, then the ending inventory will be less compared to the beginning inventory. In such a situation, if a company is using LIFO (Last In First Out) method, some older units are assumed to have been sold. This is called LIFO liquidation. What’s at play here is the price of the older versus newer inventory. In the event of poor purchases or production, managers dip into lower, older costs of inventory. This results in better gross profits and margins which is erroneous. During inflation when inventory costs are rising and LIFO liquidation is experienced, then an increase in gross profits is realized because of the lower cost of the older inventory that’s liquidated.
Margin ratios help understand the relationship between a firm’s earnings and its profits or sales. They help compare a company’s performance with its close competitors as well. These margins usually have a pattern. Abnormally high margins without cause need to be investigated further.
Firms can extend the useful life of their assets beyond their term. This helps in the reduction of depreciation costs and hence increased operating income.
Unjustified pension assumptions that reduce pension expenses and thereby liabilities and should be examined further.
Year-end surprises or unexpected earnings should also be checked closely for source income. Is it really an unexpected earning or a false earning? If it is indeed an unexpected earning, what are the causes for it?
Equity method investments can overstate earnings as well as the use of special purpose vehicles (SPV). An overuse of either is indicative of improper financial reporting and accounting fraud.
Read more: Why Do Companies Manipulate Their Financial Reports