Red Flags on Financial Statements

Question 1

What are the 3 red flags on the balance sheet?

Answer 1

Creating subsidaries to hold liabilities or incur expenses

Use of synthetic leases

Changes in value for inventory & accounts receivable

Question 2

What does Creating subsidaries to hold liabilities or incur expenses
involve?

Answer 2

Setting up a subsidiary that is not wholly owned by the parent company. This then does not have to be recorded on the parent’s financial statemets.

Question 3

What does use of synthetic leases mean?

Answer 3

Setting up a SPV to purchase an asset and then lease it back to themselves. This keeps it off balance sheet and the liability at the end of the lease is overlooked.

Question 4

Why are changes in value for inventory and accounts receivable a red flag?

Answer 4

While changes in valuation might be legal, the reason for those changes needs to be questioned.

Question 5

What are the red flags on the income statement?

Answer 5

Booking lump-sum payments as current sales

Considering a large shipment of goods as “sales” - channel stuffing

Improper capitalisation of expenses / delaying expenses

Question 6

What is meant by booking lump-sum payments as current sales?

Answer 6

When payment is received for services that take place over a number of periods. This payment should be spread across the relevant periods. Instead, some companies will book the entire payment as sales in the current period.

Question 7

What is Considering a large shipment of goods as “sales”

Answer 7

When a company send a large amount of products to a distributor, but record it as a sale, despite the fact the goods could be returned / not sold.

Also known as Channel Stuffing or Trade Loading

Question 8

What is improper / delayed capitalisation of expenses?

Answer 8

When a good / service is expensed across a number of periods, or not recorded immediately despite having no future economic benefit and therefore needing to be recorded in the current period.

Question 9

Why is the statement of cash flows less open to manipulation?

Answer 9

Companies cannot use creative accounting practices to create cash.

Question 10

How can readers potentially spot fraudulent activity?

Answer 10

Trend Analysis - by comparing historic and present statements and looking for discrepancies or unpredicatable patterns.