The first place to start to investigate red flags or shenanigans is the company's reported income statement, balance sheet and statement of cash flows and changes in owners' equity. Some red flags to be aware of are the following:

  • Large swings year-over-year, signifying some sort of event of change in accounting methods.
  • Any ambiguities noticed in reporting functions that look out of place.
  • A change in auditors, especially if the previous auditor was on board for an extended period of time.
  • An increase in footnotes or a combination of all the above.

Keep in mind that while these changes may not signify manipulation, these anomalies need to be adjusted when comparing one company to another.

Besides reported financial results from the company, here are other sources used to investigate potential red flags and shenanigans.

  • Press releases
    Press releases can provide an analyst with useful information. That said, they must be used and analyzed diligently.
  • Securities Exchange Commission filings
    Securities filings are forms such as the Form 10-K (annual), 10-Q (quarterly), 8-K (special events) and 144 (corporate insider activity), and annual reports, proxy statements and registration statements.

    Armed with these documents analysts should look in:

    The Auditor's Report
    Red flags include:
    Inclusion of a qualified opinion
    No audit committee, or audit committee comprises mostly of related parties

    Proxy Statement
    Red flags include:
    pending lawsuits or other contingent liabilities, special compensation plans or perks for officers and directorsOff-balance-sheet transactions

    Footnotes to Financial Statements
    Red flags include:
    abnormalities found in the accounting-policy descriptions and unbilled receivables
    Off-balance-sheet transactions
    Changes in accounting principles and estimations

    Management Discussion and Analysis (MD&A)
    Red flags include:
    Large planned expenses
    Decreased liquidity
    Abnormal need for working capital

    Form 8-K
    This will provide information on:
    The company's acquisition and divestitures
    Change in auditor – If a company changes auditors, it could be because the previous auditor did not want to sign off on the financial statements.

    Form 144
    Red flags include:
    Insiders selling a large portion of their holdings

  • Interviews with the Company
    Company interviews are also a good way to get close and personal with a company's management and ask some more targeted questions. Individual investors typically do not take this extra step unless they own a significant amount of stocks. They instead rely on analysts' reports and opinions where it should be verified that the analyst has met with the company and preferably visited the company on site.
  • Commercial Databases
    Analysts can also make use of commercial databases such as LexisNexis and Compustat to screen for companies displaying potential warning signs of operating and accounting problems.


Introduction

Related Articles
  1. Managing Wealth

    Financial Auditor: Job Description & Average Salary

    Discover what it means to hold a financial auditor position, including typical job duties, education and training, required skills and expected salary.
  2. Investing

    Look For These Red Flags In The Income Statement

    Companies can overstate their revenues and understate their losses to boost investor confidence. Learn how to spot the these red flags in income statements.
  3. Investing

    What Does an Auditor Do?

    An auditor ensures that organizations maintain accurate and honest financial records.
  4. Managing Wealth

    Financial Auditor: Career Path & Qualifications

    Learn more about what it takes to become an internal or external financial auditor, and determine whether the profession is right for you.
  5. Managing Wealth

    Internal Auditor: Job Description & Average Salary

    Learn about what the job of internal auditor entails, as well as the median salary, education and certifications required and future career path.
  6. Managing Wealth

    Career Advice: Accounting Vs. Auditing

    Understand the subtle distinctions between accounting and auditing, and learn what each offers a new graduate in terms of salary, job security and daily life.
  7. Managing Wealth

    Spotting Companies In Financial Distress

    What are the warning signs that a company is struggling - or worse, sinking - financially? Read on to find out.
  8. Markets

    SEC Filings: Forms You Need To Know

    The forms companies are required to file provide a clear view of their histories and progress.
  9. Professionals

    Internal Auditor: Career Path & Qualifications

    Find out what kind of work internal auditors do in large organizations, and learn more about how to get started working in the field.
  10. Trading

    Detecting Financial Statement Fraud

    Find out how to tell if a company is manipulating its financial data, so you don't invest in the next Enron.
Trading Center