Financial Reporting Problems and Warning Signs

The table below summarizes some (i.e. not comprehensive) common financial reporting problems and the warning signs associated with those problems.

RevenueOverstated revenue.Large increases in accounts receivable.Look for increases in days sales outstanding (DSO) as this may indicate questionable credit sales by the company.
RevenueMisclassification of non-operating or non-recurring revenue as operating revenue.The company changes items included in calculation of earnings.
ExpensesUnderstating 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.
ExpensesImproper 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.
ExpensesClassifying 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.
LiabilitiesOff 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.
GoodwillAvoiding 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 FlowsCash 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.

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