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Red flags in statements

Financial fraud does not happen overnight. It happens through small decisions, repeated over time, that gradually push the boundary between aggressive accounting and outright dishonesty. Enron did not become a criminal enterprise in one quarter; it took years of small decisions, each one rationalizable at the time, that collectively amounted to a house of cards. The same was true of Wirecard, Theranos, and many other frauds.

The good news is that these small decisions often leave traces in the financial statements. An investor who reads the statements carefully and knows what to look for can spot the warning signs before the fraud becomes obvious. This chapter covers the most common red flags: patterns in the numbers and accounting treatments that should trigger skepticism and deeper investigation.

Revenue red flags​

Revenue is the lifeblood of any business, but it is also the easiest place to commit fraud. A company can record revenue too early, inflate the amount, or record sales that are not real. Here are the warning signs:

Receivables growing faster than revenue. If accounts receivable grow faster than revenue, it means the company is collecting cash more slowly than it is recognizing revenue. This can be innocent (extending longer payment terms to attract customers), but it can also be a sign that revenue is being recorded before cash is likely to arrive, or that receivables are not collectable.

Channel stuffing. A distributor or retailer commits to buy large volumes of inventory, but the seller knows the distributor will not be able to sell the inventory. The seller records the sale as revenue (inflating the top line) while the distributor ends up with excess inventory. This is fraud because the revenue is not real—the goods will be returned.

Round-tripping. Company A sells goods to Company B, and Company B immediately sells identical goods back to Company A. The revenue circle creates the appearance of sales activity, but no real value has been created. Both sides record the revenue, inflating both companies' top lines.

Side agreements. The company records a sale to a customer, but there is a side agreement (not disclosed in the financial statements) that allows the customer to return the goods or delay payment. If the side agreement makes the sale contingent, the sale should not be recorded as revenue. If a company has side agreements that differ from the standard terms, it is a red flag.

Margin red flags​

Gross margin diverging from peers. If your company's gross margin is five percentage points higher than its closest competitor, and you have not identified a genuine competitive advantage, be suspicious. Companies with structurally similar businesses should have structurally similar margins. If one company has much higher margins, either it has a real advantage or it is recording revenue or expenses differently.

Operating margins improving while revenue is stagnant. If revenue is flat but operating margin is expanding, the company is achieving more with less. This can be real (executing a cost-reduction program), but it can also be a sign of accounting games. Is the company cutting actual costs, or just shifting them? Is it depreciating assets more slowly? Is it taking smaller reserves for doubtful accounts?

Unusual capitalization of costs. Companies can choose whether to record certain costs as immediate expenses (hitting profit today) or as assets (hitting profit over many years as the asset is depreciated). Software development, customer acquisition costs, and internal labor can all be capitalized. If a company is capitalizing costs that competitors are expensing, its profit will look better, at least in the short term. If capitalization is increasing significantly year over year, investigate.

Balance sheet red flags​

Rapid inventory growth. If inventory is growing much faster than revenue, the company is building up inventory it cannot sell. This can signal demand weakness before it shows up in revenue. It also ties up cash that could be returned to shareholders.

Rising accounts payable without rising inventory or working capital. If the company is paying suppliers more slowly (stretching payables) without increasing inventory, it might be facing a cash crunch and conserving cash by delaying payments.

Large asset values with vague descriptions. Goodwill, intangible assets, and deferred tax assets can be substantial but are often difficult to assess. If a company has a large "other assets" line or large goodwill that management does not explain, be skeptical. These can be parking places for costs that the company does not want to expense.

Rapid changes in accounting estimates. If the company suddenly changes how it reserves for doubtful accounts, how it depreciates assets, or how it values inventory, it might be managing earnings. Small changes are normal; large changes deserve investigation.

Cash flow red flags​

Profit growing while cash flow is declining. This is one of the most reliable fraud signals. If a company is reporting growing profits, but the cash flow statement shows that operating cash flow is declining or stagnant, the company is not generating cash from its profits. Where is the profit coming from? It might be accounting. This is a strong signal to investigate further.

Large non-cash charges and one-time items. If a company records large depreciation charges, impairments, or other non-cash charges, operating cash flow will be higher than reported profit (because these are added back). If the company is relying on large non-cash add-backs to make operating cash flow look good, be skeptical.

Increasing use of financing activities to fund operations. If the company is constantly issuing debt or equity to fund operations (as opposed to funding expansion), it might be burning cash in the core business. This is unsustainable.

Red flags in relationships and transactions​

Related-party transactions. The company does business with entities owned by management or board members. These transactions are inherently suspect because the parties cannot negotiate at arm's length. If related-party transactions are increasing or becoming more complex, investigate.

Customer concentration. If most of the company's revenue comes from a few large customers, the loss of one customer could be catastrophic. If this concentration is increasing, the company's revenue is becoming more fragile.

Supplier concentration. If the company depends on a few suppliers for critical inputs, supply disruptions could halt production. If supplier relationships are deteriorating (the company is switching suppliers frequently, paying higher prices, or facing longer lead times), it is a warning sign.

Red flags in footnotes and disclosures​

Shrinking disclosure. If management's discussion section is shorter, or if the company provides less detail about operations and segments than it did in previous years, be suspicious. Companies often reduce disclosure when they have bad news to hide.

Contradictory statements. If the business description emphasizes a particular product as critical to the future, but the segment reporting shows that product declining, there is a contradiction. These contradictions warrant investigation.

Unusual auditor language. Read the auditor's report carefully for hedging language or qualifications. If the auditor says something like "based on information available to us" or "we could not fully audit this area," that is a warning sign.

Red flag combinations​

No single red flag is definitive proof of fraud. But combinations of red flags are concerning. A company with rising revenues, declining operating cash flow, growing receivables that are not typical for the industry, and rapid expansion of a particular product line is worth investigating deeply. A company where the CEO just changed auditors, the audit firm issued a going-concern warning, and insider selling is accelerating is in distress.

The best fraud detection is not sophisticated. It is careful reading and questioning. If something does not make sense, if the numbers do not seem to fit the business description, if the trends are inconsistent with the company's competitive position, investigate. Many of the largest frauds were obvious to anyone who read the statements carefully and asked hard questions.

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