Research

25 Red Flags for Financial Statement Analysis

Accounting includes many instances where choices of methods or estimates and decisions on disclosure must be made. The selections made impact the income statement, balance sheet and footnote information. Choices and decisions that increase net income, and increase asset or decrease liabilities or make the understanding of complex issues unclear are said to be aggressive or low-quality choices. Choices and decisions that decrease net income, and decrease assets or increase liabilities or make complex issues easy to understand are called conservative or high-quality choices.

The following areas include the most prominent places in the financial statements where accounting choices or disclosure decisions can be selected that involve high or low-quality choices:

  • Accounts Receivable Allowances for Doubtful Accounts and Bad Debt Estimates
  • Inventory and Cost of Goods Sold Valuation
  • Investment Valuation
  • Operational Assets Depreciation Method
  • Operational Assets Estimated Life
  • Intangible Assets
  • Impairments of Operational Assets
  • Debt Valuation
  • Lease Classification
  • Pension Liabilities
  • Pension Estimates (discount rate, expected earnings growth rate, wage growth rate)
  • OPEB’s Liability
  • OPEB’s Health Care Trend Rate
  • OPEB’s Health Care Trend Rate
  • Options’ Cost Disclosure
  • Derivatives Use and Valuation
  • Deferred Taxes Use
  • Contingency Disclosure
  • Off Balance Sheet Items
  • Capitalization vs Expense Decisions
  • Revenue Recognition
  • “Restructuring” and Other Non-recurring Charges
  • Discontinued Operations Items
  • Extraordinary Items Existence
  • Cumulative Effect of an Accounting Change Items
  • General Disclosure

A good financial statement analysis requires that these areas be examined and the choices made by the company’s management determined. Once the general trend of choice selection is determined the analyst can then decide if corporate management is acting in a manner that inflates earnings (if, in general, the more aggressive choices have been made) or if the choices made reveal a tendency towards a ‘conservative’ record of financial activity. This determination provides useful insight to the evaluation of the financial statements and to the mind-set of management when making further investment decisions about a company. Remember, it is not usually possible for any company to make all the conservative, high-quality accounting choices that can be made. An analyst should look for a pattern of choices to make their determination of the financial management’s cumulative choice of quality.