What are accounting red flags?
A company’s profit is not a purely “measured” number. When a sale counts as income, which costs are shown now and which are spread over several years, how much of the money owed will actually be collected: all of this needs management’s judgement. So profit can be dressed up somewhat even within the rules, let alone when the rules are broken.
Accounting red flags are the signs where one part of the accounts does not fit with another. One red flag does not mean fraud; there is often an ordinary business reason behind it. But when several appear together, it is important to ask questions.
Say an imaginary company, “Rupsha Foods Ltd”, reports profit growing 30–40% a year for three years in a row. Yet its cash flow statement shows cash from operations close to zero or negative every year, and the money customers owe it is growing much faster than sales. The profit is on paper, but it is not reaching the bank. The company and numbers are only an example.
Why it matters to an investor
- Most of what you know about a company comes from the accounts it publishes itself. If those accounts are wrong, every ratio built on them, EPS, P/E, ROE, is wrong too.
- Before a big collapse there are often signs in the accounts: profit that doesn’t match cash, growing debt, late reports.
- If you decide only on profit and dividend headlines, you are looking at exactly the part that is easiest to dress up.
- When doubts arise you get the chance to read more, ask questions or stay away, which is far cheaper than regret later.
When profit and cash don’t match
The most useful test is simple: put net profit from the income statement next to “operating cash flow” from the cash flow statement, over several years. One year can differ, but if profit runs well ahead of cash year after year, the question is where that profit actually is.
- Receivables growing much faster than sales: sales are being booked, but the money isn’t being collected.
- Inventory growing faster than sales: goods aren’t selling, or stock is being valued too high.
- A large part of profit coming from “other income” or one-off gains, such as selling land or shares. The core business may be weak.
- Treating ordinary costs as “assets” and spreading them over years (capitalising them), so this year’s profit looks bigger.
Signs in the audit and disclosure
- A “qualified opinion”, an “emphasis of matter” or doubts about “going concern” in the auditor’s report: the auditor is pointing out a problem or uncertainty.
- Frequent changes of auditor or accounting policy, or annual reports and AGMs coming late.
- Large related-party transactions: buying, selling, lending or advancing money to other businesses linked to the directors.
- Notes to the accounts that are vague, or important details that are hard to find. The real story often sits in the notes.
Lessons from Enron and Wirecard
Enron was a giant US energy company. Using partnerships and “special purpose entities”, it kept large losses and debts off its accounts. In November 2001 it restated its profits since 1997, cutting them by $586 million, and on 2 December 2001 it filed for bankruptcy. Shares that traded above $80 in January 2001 were worth less than 70 cents a year later.
German payments company Wirecard filed for insolvency in June 2020, after it emerged that about €1.9 billion of cash shown on its balance sheet could not be found and probably never existed. Both cases teach the same thing: a big name, fast growth or a well-known auditor do not by themselves make the accounts safe.
Worked example
- Say Rupsha Foods’ sales rose in a year from Tk 100 crore to Tk 120 crore, a 20% increase. Over the same time, money owed by customers rose from Tk 15 crore to Tk 36 crore, a 140% increase.
- Days to collect = receivables ÷ sales × 365. Last year: 15 ÷ 100 × 365 ≈ 55 days.
- This year: 36 ÷ 120 × 365 ≈ 110 days.
Result: customers are taking about twice as long to pay. Perhaps sales were boosted by selling more on credit, perhaps some of the money will never be collected. It is not proof, but it is a question worth chasing in the notes of the annual report.
Common mistakes
- Looking only at EPS and dividends, without reading the cash flow statement and the auditor’s report.
- Treating one red flag as proof of fraud, or the opposite: brushing off several at once with “there must be a reason”.
- Taking a big name, a well-known auditor or fast growth as a guarantee of safety.
- Looking at just one year. You need several years side by side to see the trend.
Always check profit against cash: profit year after year with no cash coming in is the most familiar red flag of all.