Accounting Warning Signs

I just wanted to provide some accounting warning signs that professionals can use in business valuations. These signs are to assess the chance of accounting malfeasance and are not necessarily the same checks you would use in a financial health assessment.

Basically, when looking at financial statements there are many things that can occur in the background that might not be obvious from the statements themselves. When evaluating the statements, professionals need to make sure that they investigate issues as they arise and adjust for them. There is a lengthy list of accounting warning signs that can come up and you can read Financial Shenanigans or the CFA curriculum to get a more better idea of everything that can go on.

Generally, accounting warning signs can occur on any of the three financial statements and either have the characteristic of overstating items, understating items, or resulting from a potential problem like cash collection.

On the income statement, spikes in revenue without clear operational rationale to support them could be an issue. Cyclical businesses or those with sales tightly packed around product releases (such as videogame production companies) will likely have no issues passing this check. Other businesses with generally stable, consistent revenues shouldn’t see spikes often however. For them, these could represent overstated revenues in the form of aggressive revenue practices such as year-end channel stuffing (where business send out product that wasn’t requested and defy accrual accounting by recording revenue before transactions are complete and without reasonable assurance that a reversal will not occur).

Expenses can be understated by capitalizing operating expenses (like sales commissions). Capitalization can occur with capital expenditures (long term expenses), where as operating expenses (expected to have benefits in the year due) are expensed. Capitalization would delay the full recognized expense and overstate earnings before interest and tax (EBIT) margins.

On the statement of cash flows, one interesting sign to pay attention to, and this was something I looked at in detail in my credit analysis on Capcom, is the cash flows from operations (CFO) to EBIT ratio. EBIT is also known as operating income, so effectively the ratio would tell you how much cash was actually collected from operations. This number should be around 1, otherwise the company may have a cash flow collection issue, which could signal aggressive revenue recognition or credit collection issues. Alternatively, the same ratio may be very volatile (as with Capcom and, generally, other videogame companies), which could suggest the company is gaming revenue collection or recognition for some reason.

I’ve talked plenty about revenue collection already but obviously accounts receivable (balance sheet) growing faster than revenues could be a problem. Another sign to watch is the inventory turnover ratio (COGS / avg Inventory) falling, which would typically suggest that inventory is getting held onto longer (rather than COGS going down). This could suggest slowing sales (though usually COGS moves with sales, so the ratio would stay approximately the same) and it could signal inventory management issues.

Anyways, there's a long list of accounting ratios and signs to look out for during a business valuation. Make sure to look into those. You may also find them useful for your own business.

If you found this helpful or enjoyable, please consider subscribing to our newsletter for more.  

You can reach out to us here for consulting services or here to discuss booking a workshop to learn useful skills and help you get more familiar with us.