Financial reports are the most objective way to assess a entity's health, as they say - the numbers don’t lie. The numbers indicate that all is well - if that is the case - and will alert to the first signs of trouble if they are approaching.
Past failures, like the infamous Enron scandal, show that financial reports are subject to error and misstatement. These problems are often not evident, difficult to detect and may even be purposely hidden. Critical to uncovering these problems is knowing what to look out for.
Business owners and potential investors analysing financial reports must know and be able to identify the many red flags that indicate the financial reports may not be as they seem.
In this article, we outline our top 10 financial reporting red flags that serve as an indication the numbers could be inaccurate, or at least at risk of misstatement.
1. Are the numbers too good to be true?
If they're too good to be true - then they probably are!
So, what's “too good to be true?” Take a look at your financial reports, are the actual results far better those budgeted? Is the entity suddenly outperforming the competition without a clear cause?
When your gut feeling is that something isn't right, don’t ignore it. If you or others preparing the financial reports don’t have confidence in the numbers, take action and investigate. Understanding the ‘why’ behind the numbers is critically important for proper financial management.
2. Auditors vs Management
A change in auditors that is out of cycle (i.e. not every 5 years as required by the ASX) or due to a disagreement, could be cause for concern.
During an audit, auditors track all errors, noting which have been corrected, and which haven't. This is typically called the 'Summary of Misstatements' which is included in the *Auditors Report to Management.
Management and auditors can sometimes have a difference of opinion. One example of this is when management is reluctant to fully recognise early potential losses, but auditors decide to take a conservative view. Differences such as these can manifest into errors and misstatements within financial reports, frequently seen in provisions such as warranties, stock obsolescence and doubtful trade debtors.
*The Auditors Report is a great place to start if you happen to be looking for red flags!
3. Accounting Policies
Unusual accounting policies, practices and methods can sometimes point to misstatement and make it difficult to compare performance to similar businesses.
An example that comes to mind is the R&D Tax Incentive which, at one time not long ago, could be reflected in three different ways:
- grossed-up number in Other Income;
- as net of tax in Other Income; or
- merely the net benefit of the incentive reflected in the Tax Expense line of the Profit and Loss Statement.
These different applications will result in very different EBITDAs and Net Profit before Tax.
Estimated asset lives that differ from industry norms may cause an under-recognition of depreciation expense, over-stating profits or a balance sheet with values assigned to worthless assets. When Estimated Asset Lives differ from industry norms, it’s time to have a closer look.
Changes to an entity and its financial reporting can come in many forms, for example:
- trends in the balance sheet and profit and loss ratios (e.g. debt to equity or working capital cycle days can point to worsening operating conditions);
- multiple and/or large late adjustments to monthly management or annual accounts due to errors or inaccurate data; or
- a change in Senior Management which could mean a change in management style and internal culture.
Any change within an entity should be flagged and understood as to the impact it could have on the financial reports.
An anomaly in the financial report, where numbers are higher or lower than what would normally be expected should be investigated.
There are a number of common anomalies that serve as a red flag and require further inspection.
- If the Other Expenses category of the Profit and Loss Statement is very high it should alert you to a potential problem. Abnormally large legal fees or management trying to hide excessive travel expenses are commonly found to be concealed in this category.
- Invoicing a high proportion of monthly or quarterly sales in last few days of a period may indicate that the month-end cut-off is not being properly adhered to, with sales being invoiced earlier than they should be.
- A build-up in the value of work-in-progress, fixed assets or intangibles above expectations may be signs that operating costs are being capitalised, instead of being expensed through the Profit and Loss Statement.
Complex transactions, both internal and with third-parties, that are not understood or do not appear to have sound economic basis should be regarded with caution. Going back to our example from above, Enron used 'limited liability special purpose entities' to transfer liability from its accounts. Today, similar complex structures can be misused to deceive.
7. Bonuses Based on Performance
When management's compensation is tied closely to performance and bonuses, there is a greater incentive to manipulate the financial results. Also, an over-emphasis on short-term performance in relation to awarding bonuses could lead to managerial decisions that are not in the best interest of the entity long-term.
8. Increasing Gross Profit Margin
Gross Profit is used to calculate the proportion of money left over from revenue after accounting for the cost of goods sold. An increasing Gross Profit % may not always be a good sign, particularly when overheads are more than outpacing it or sales are declining, as this eventually leads to a net loss.
Gross Profit Margin should not be looked at in isolation but viewed together with sales levels and overheads.
9. Debt Covenants
Where an entity is on the verge of breaching a debt covenant and the loss of a credit facility is looming overhead, there is a huge temptation for management to misstate the accounts or the calculation of the covenant leverage ratios.
In order to check the potential of such impending problems, get more detail on the covenants themselves and the level of safety margin.
10. Rising Inventory or Debtors in Relation to Sales
Rising inventory or debtors can be a sign that future stock write-downs are to follow, or that there are impending bad debts.
Analysis of debtors and inventory should be done to understand the drivers of these increases, and also what can be done to mitigate any negative outcomes.
It is critical to be able to identify red flags. However, detection, investigation and resolution are often very technical, and at times, beyond the know-how of any one individual.
For all entities, it is critical that reporting is done accurately, and that there are ‘checks and balances’ in place to avoid any undetected errors and misstatements in the financial reports.
It is always recommended to have an expert involved in the financial management or review of any financial reports. Whether you’re a business owner or investor, obtaining and understanding the correct information is the only true way to make sound and successful decisions about your next move.
If you have any questions, chat to us, we're always happy to help. We offer a Virtual Chief Financial Officer service to businesses that are large enough to benefit, but too small to hire an internal CFO just yet. With this service, businesses get all the benefits of a CFO, but will only have to pay for what's needed, when it's needed. For more, contact us.
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