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.
| 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. |
LESSONS
- CFA Level 2: Financial Reporting Part 3 – Introduction
- Various Definitions of Earnings
- Total Comprehensive Income
- Earnings and Cash Flows
- Derivatives Hedging and Financial Reporting
- Cash Basis Accounting vs. Accrual Basis Accounting
- Management Motivations for Financial Statement Manipulation
- Measures of Earnings Quality
- Analyzing Earnings Quality - the Accruals Ratio
- Financial Reporting Problems and Warning Signs
- Financial Statement Analysis - Ratio Analysis
- Adjusting a Company's Reported Financial Statements
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