The term “fraud triangle” means that investors and industry professionals relying on the accuracy of financial statements should watch for these three interconnected risk factors:
Of course, the “reversal” never comes soon enough and the postmortem conclusion is always the same: It is always better to simply tell the truth and focus on fixing the problem, instead of covering it up!
Based on studies and reviews of recent high-profile corporate scandals, a number of accounting warning signs came under spotlight and intense regulatory scrutiny.
As per Generally Accepted Accounting Principles (GAAP), public companies are required to disclose their revenue recognition policies in financial statements’ footnotes. Financial analysts consider footnotes as THE place to look for red flags, which, although may not necessarily be pointing out anything illegal, could be identifying certain inappropriate revenue reporting policies. For example, it is inappropriate to recognize revenues earlier than they were realized, such as at the time of signing a contract but before the actual delivery of contracted goods or services.
When cash flows are falling out of line with reported earnings, something could be amiss. If a company is reporting positive and increased earnings while cash flows from operations are declining, accounting shenanigans could be the reason. There is a metric called cash flow earnings index, (calculated by dividing operating cash flows with net income), which can be useful when looking for red flags. If this ratio is constantly below 1, or declining from one quarter to the next, it may indicate suspicious discrepancies between cash flows and earnings.
If both inventories and sales are increasing within a certain period, something is likely amiss again. Otherwise, how else to explain increasing sales of inventories when inventories are also growing. Possible explanations include poor inventory management, obsolete inventories, or purposely overstating inventories to boost gross and net operating profits.
Capitalizing costs, that is, deferring them to be paid off in smaller increments through depreciation or amortization is a frequently used and quite legal accounting method of smoothing a company’s earnings. However, deferral of ineligible expenses by classifying them as capital costs can also be used to manipulate earnings, as was the case with the disgraced WorldCom.
There is also something called recording expenses “below the line” and classifying bona fide, incurred-in-the-normal-course-of-business expenses as extraordinary or non-recurring expenses. This way, when a company takes a hit due to problems with its operations or inventories, it can “explain” them away as something that does not happen often or regularly.
It is always a good idea to treat surprise earnings growth with suspicion and compare a company’s bottom line performance to the overall economy, industry or its peers. True, superior performance could be happening due to a company having either superior management or product or both. However, it could also be due to accounting shenanigans, such as account receivables growing faster than revenues or having lower turnover ratio, indicating potentially non-existent sales.
Notably, if red flags are raised in the course of a company’s analysis, perhaps the best advice is not to jump to conclusions. Just because there are certain accounting risk factors, it does not necessarily mean the company’s management engages in fraudulent and manipulative practices. It should mean, however, that an investor would be wise to invest both extra time and effort when researching a stock and performing due diligence of the company.