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CFA Level 1 - Finding Shenanigans Finding Shenanigans
There are four sources of information an analyst should use to detect financial shenanigans:
1.Press releases
Press releases can provide an analyst with useful information. That said, they must be used and analyzed diligently.
2.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 auditors 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 directors
- Footnotes to financial statements – Red flags include:
- Abnormalities found in the accounting-policy descriptions
- Pending lawsuits or other contingent liabilities
- 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
3.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.
4.Commercial databases
Analysts can also make use of commercial databases such as LexisNexis and Compustat to screen for companies displaying potential warning sings of operating and accounting problems.
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