Red Flags in Financial statements: Watch where you jump!

There is a new hot stock in the market. It is enjoying an unrestrained bull run. You are interested in buying its shares, but you want to be certain that the financials are sound. Where do you begin? Well, you look at the financial statements of the company. Financial statements or reports are an objective way to assess the health and potential of a company. Analysing financial statements is crucial to get the entire picture of the company and understand its real value. Since the numbers on paper are what the company is trying to show, and one must labour to read in between the lines to gain insight. If one looks closely enough, there will be "warning signs" or "red flags": potential problems with a company's financials lurking in the corner. The goal here is to present some red flags with the hope that you will be able to identify them and conduct your due diligence before picking a stock! 

Let us look at some of the major red flags that should be a cause of concern or further investigation:

1. Auditors and Management: The tug of war

   When the financial statements are audited by a third party, they track errors or discrepancies that they identify in the financial statements under ‘Summary of Misstatements’ in their report to the management. The company’s financials juxtaposed to the auditor’s report is a good place to look for red flags. Sometimes, the management may disagree with the auditor’s report. There have also been cases in the past where auditors have colluded with companies to embellish the financials of a company. 

2. Anomalies in the financial report:

   There will be numbers that would seem odd in the context of the financial document. A sudden spike in sales reported in the last quarter, or a large sale being made out of the blue without any history of a sale of that magnitude, are just some of the examples of anomalies that need to be scrutinized. One should closely look at the Profit and Loss statement for anomalies. There may be expenses that the management is trying to hide that may be a potential problem.  

3. The conundrum of Complex transactions:

   Many times, companies will record complex financial transactions with different parties. While some transactions may be legitimate, there is a case to further scrutinize transaction that does not seem to make sound financial sense. It may be a ploy the company is using to fudge the numbers.

4. Atypical accounting practices:

   There are standard accounting practices companies need to adhere to. Sometimes, in a bid to avoid scrutiny over costs or to cover up losses, companies employ tactics such as overvaluation of assets, profit management through CSR activities etc. 

Enough theory! Let us now look at some of the biggest accounting scandals of the past:

1. The Wirecard scandal (2020):

   A series of accounting scandals led to the insolvency of this payments processing company based in Germany. Over 2 billion Euros went "missing" from the company's books, with long time auditor EY being suspected of possible malpractice in this scandal that shook Germany.

2. Satyam Computer Scam (2009):

   This is arguably one of the most famous accounting scandals in India. The scam broke in 2009 when the chairman of Satyam Computers confessed that the accounts of the company were tampered with. The cash and bank balances of the company were inflated. The aftermath of this saga involved the sale of Satyam Computers to Tech Mahindra and its subsequent merger with the same. As per SEBI's probe, the magnitude of financial misstatements was to the tune of Rs 7,000 crores!

3. The Enron Scandal(2001):

   This US-based energy and commodities company committed one of the biggest accounting scandals at the turn of the century. They fooled investors, shareholders and other stakeholders alike by keeping huge debts off the balance sheets. The scandal was brought to light by an internal whistle-blower Sherron Watkins. A movie was released in 2005, documenting the fall of the company due to corporate corruption.

With time, there have been significant improvements in accounting practices and also in the power and ability of regulatory bodies to oversee financial transactions and records. An increasingly digital world is making it easier for authorities to track and record transactions, making it harder for companies to misreport their finances. While this is a cause for hope, it still should not stop you from doing your research before investing in a company!

We hope that this article provided you with some insight into red flags in financial statements! Be wary of them! Until next time...

Know About The Red Flags In Financial Statement | ICICI Direct