Accounting red flags
None of these prove anything. Each of them is a question that deserves an answer, and several together have preceded most of the failures worth remembering.
Accounting standards permit a range of defensible treatments, and management chooses within that range. Most choose conservatively. The warning signs below identify companies choosing aggressively — which is legal, disclosed, and a reason to look harder.
1. Profit without cash
Reported profit depends on judgement about when revenue is earned and when costs are recognised. Cash in the bank does not. When net income rises steadily for several years while operating cash flow stagnates, one of the two is describing the business incorrectly, and it is rarely the cash. See free cash flow.
2. Receivables growing faster than revenue
Sales are being booked that have not been collected. Possible explanations: expansion into slower-paying markets, a genuine timing effect, generous terms offered to close the quarter, or revenue recognised before it was earned. The first two are fine. The third borrows from next quarter. The fourth is a different category entirely. See working capital.
3. Inventory growing faster than sales
Either demand disappointed or production was run hard to absorb overheads. Both lead to discounting or write-downs. See inventory accounting.
4. One-off charges that arrive every year
Restructuring in each of five consecutive years is not restructuring; it is an operating cost with a favourable label, and the adjusted earnings built on excluding it overstate what the business sustainably earns. See adjusted earnings.
5. Changes in accounting policy or estimate
Extending the useful life of assets, changing a revenue recognition policy, altering pension assumptions, switching depreciation methods. Each raises reported profit without changing cash, each must be disclosed, and each is easy to miss. A cluster of them in one year, particularly a difficult one, is a pattern.
6. Auditor changes and late filings
- A change of auditor outside the normal rotation cycle, especially with a brief or unexplained reason.
- A move from a large firm to a much smaller one.
- Repeated delays in filing.
- Resignation of the chief financial officer without a successor in place.
Any one may be innocent. Two together, in the same year, have preceded a striking number of restatements. See what an auditor does.
7. Complexity without purpose
Structures whose commercial rationale is not obvious, material off-balance-sheet obligations, or a group chart that cannot be explained in a paragraph. Complexity is sometimes genuinely necessary. It also reliably reduces the number of people who understand what is going on, and that reduction is occasionally the point. See related-party transactions.
8. The narrative moving away from the numbers
When a company's preferred metric changes repeatedly — from profit to adjusted profit to a bespoke measure of engagement — each change should prompt the same question: what did the previous metric start to show?
How to use any of this
Every flag here has an innocent explanation that is more likely than the guilty one. Rising receivables usually do reflect growth. Auditors do change for ordinary reasons. The correct response to a single flag is to look for the explanation, which is usually disclosed. The correct response to four flags at once is to consider whether you need to own this particular company at all.
The discipline underneath
Nearly every item above is found by comparing two numbers over five years — profit against cash, receivables against revenue, inventory against sales, capex against depreciation. Not one requires an accounting qualification, and not one can be done from a summary page. It requires opening the filing.