Financial statement manipulation emanates from either timing or location (classification) bias in revenue recognition and/or expense recognition. Timing bias occurs when a company either accelerates or defers recognition and location bias occurs when a company classifies an item incorrectly (i.e. recognizing an item in other comprehensive income (OCI) when it should be routed through profit and loss).
In order to identify reporting and earnings quality issues, an analyst needs to analyze revenue, inventories, capitalization policies, the reasonableness of estimates, impairment and restructuring charges, acquisition accounting, and above all the company’s culture.
Revenue
Review revenue recognition policies (particularly risk of premature revenue recognition, barter transactions, rebate programs, and multiple-deliverable arrangements); compare a company’s revenue trend with competitors, calculate receivable turnover and days sales outstanding ratios and analyze across time. Analysis of asset turnover ratio can reveal whether management is most likely under pressure to show improved efficiency.
Inventories
Analysis of inventories should complement revenue analysis. An analyst needs to compare a company’s inventory policies, movement, and ratios with its peers. Calculate inventory turnover ratios, and if a company uses LIFO, identify any LIFO liquidation.
Capitalization
Incorrect expense capitalization is the second biggest reason for financial misstatements, second only to incorrect revenue recognition.
Comparison of cash flow with net income
If net income is backed by cash flow, it is a good sign. Analysis of the cash flow ratios is useful.
Company culture
An analyst needs to look at the warning signs in the context of the company’s culture, the unwritten code, and ethos of a company evident from management’s actions.
Restructuring and impairment charges
While investors sometimes see large restructuring or impairment charges as a sign that a company is ready to focus on its core business, it also highlights that prior period expenses were most likely understated. Hence, in conducting analysis, an analyst should adjust historical results to reflect the restructuring and/or impairment charges.
Too many mergers and acquisitions
If a company engages in very frequent acquisitions, it might indicate a growth-at-any-cost culture, which is a potential red flag in the context of potential misstatements.
Other warning signs
There include:
- Depreciation: An analyst needs to check reasonableness of depreciation methods and associated estimates (salvage value, useful life).
- Fourth-quarter surprise: If a company’s fourth-quarter results are inconsistent with other quarters and with previous periods, it might be an indication of earnings management. It is because management may be adjusting the fourth quarter figures more aggressively to reach the desired earnings goal.
- Presence of related-party transactions.
- Inclusion of non-operating income or one-time sales in revenue.
- Classification of expenses as non-recurring.
- Gross margin or operating margin not in line with the peer group.
These signs should be analyzed collectively. Other red flags include (a) a start-up company’s consistent record of meeting growth projections, (b) minimum disclosure made by a company, and (c) management’s excessive emphasis on earnings reports (for example because their compensation is heavily linked with operating results).