Accounting Red Flags

Why this matters

Most companies report honestly, and most oddities in a set of accounts have dull explanations. But the cost of missing a real problem is high, and the signs are often visible in public documents before the news breaks. This lesson collects them in one place. Use it as a routine check on any company being researched, in the same spirit as Fact, Interpretation, and Confirmation Bias: the goal is to look for evidence against a company as carefully as evidence for it.

Group 1: numbers that disagree

The three financial statements describe the same business, so they should tell the same story.

• Profit rising while operating cash flow falls for more than a year or two.
• Receivables growing much faster than revenue. Days of receivables climbing year after year.
• Inventory growing much faster than sales. Days of inventory climbing, especially if margins are also slipping.
• Deferred revenue falling while revenue grows, at a company that's paid in advance.
• Capital spending rising faster than revenue while expenses fall as a share of revenue. That can mean ordinary costs are being recorded as assets.
• Margins far above every competitor's with no clear reason in the business.
• Large cash balances alongside heavy borrowing, or interest income that looks too small for the cash reported.

	Year 1	Year 2	Year 3
Revenue	500	550	616
Net income	40	46	54
Cash from operating activities	44	32	16
Operating cash flow ÷ net income	1.10	0.70	0.30
Accounts receivable	55	78	111
Days of receivables	40	52	66
Cost of goods sold	300	330	370
Inventory	49	68	96
Days of inventory	60	75	95
Allowance for unpaid receivables, as a share of receivables	4%	3%	2%

The income statement shows a company growing steadily: revenue up 23% in two years and profit up 35%. The rest tells a different story. Receivables and inventory have both roughly doubled. Cash from operations has fallen by almost two thirds. And while customers take longer to pay, the company is setting aside less for the ones who won't. If the allowance had stayed at 4%, it would be $4.4 million in year 3 instead of $2.2 million. No single line proves anything. Together they say the profit growth isn't showing up anywhere else.

Group 2: estimates that keep helping

Every estimate has a reasonable range. Watch the direction of travel.

• Allowances and reserves shrinking against the balances they cover.
• Useful lives extended, or residual values raised.
• A higher expected return or discount rate in the pension note than last year, or than similar companies use.
• A valuation allowance on deferred tax assets released in a year that needed the help.
• More costs treated as assets: software development, contract costs, or "other assets" growing faster than the business.
• Reserves released into profit. The SEC's chairman described companies building up reserves in good years to draw on in bad ones as stashing accruals in "cookie jars".¹

A company that meets or narrowly beats expectations every quarter, with a helpful change of estimate each time, deserves more suspicion than one whose results bounce around. Real businesses are uneven.

The rest of this lesson is for members

Still to come in this lesson: Group 3: presentation, Group 4: the people and the process, How to respond, the key takeaways, and 2 quiz questions with explanations.

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