A business or company always requires capital and stable hold on the same. While startups generally seek investors for funding, established companies rely on their liquid assets and shares which they prefer utilizing for business growth. In any business or industry, the ebb and flow of income heavily depend upon the market and its condition. As it’s important to spot accounting red flags, you should also have your finance and accounting managed responsibly.
Having a finance department in your company will have a significant impact on your business growth. While your finance team holds the responsibility of organizing, monitoring, controlling, planning, and directing your company’s monetary resources, have you ever noticed any red flags or checked if your accounts are managed with meticulous care?
What are Accounting Red Flags?
In business, a red flag is a sign of warning; it indicates possible issues that can turn out to be potential threats to a company’s financial statements. Red flags can be described as anything undesirable in the financial records. Yes, they can be anything. Before investing, apart from the potentials of a company, analysts and investors generally look for red flags to get a fair-enough understanding of what could be the financial position of that company in the future.
Let’s now take a look at one of the most shocking fraud scandals of all time, which could’ve averted if red flags were noticed timely.
An Example of Accounting Scandal
Ted Baker, a luxury clothing store chain founded in March 1988, had its first store in Glasgow. The company then expanded and included in the list – FTSE 250 with having 490 stores and concessions all over the world. In Aug 2018, KMPG was fined £2.1 million by the FRC (Financial Reporting Council) for misconduct on the company’s financial statements in the year 2013 and 2014. FRC personally rebuked KPMG partner Michael Francis Barradell and fined with £46,800.
Therefore, it is vital to keep looking for red flags to prevent any possible fraud.
10 Accounting Red Flags
1. Red Flags You Can Spot on Your Financial Statements
Many companies usually have ‘other expenses’ that is either inconsistent or too small to be quantified. This is pretty normal in income statements and balance sheets. In case you notice these expenses having higher values, red flag “spotted.” You should find out what they were spent on and for how long your company has been spending big money as other expenses. Also, keep a check on the same as this would probably happen again.
Pending income, for example; accounts receivable and the money that has already been used on inventory is money which will not generate a return. Growing numbers of accounts receivable are just another red flag.
“Financial statement fraud is the most costly form of occupational fraud, causing a median loss of $1,000,000” as per a research conducted by ACFE (Association of Certified Fraud Examiners).
2. Red Flags In The Income Statement
Revenue misrepresentation is common malpractice. Some common ways to present manipulated revenues include recording revenue before a possible earning or just making up revenue that has never even eared. This is possible by making fraudulent sales to another company; for instance,
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Selling to a sister company and canceling the sale immediately. (income fraud)
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Recording incomplete sales as they are bound to some terms and conditions, for example; entering the whole amount of an installment sale. (red flag)
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Representing undelivered consignment as completed sales
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Altering contracts to boost sales.
All the above-discussed examples can happen in real either intentionally or by mistake. Therefore, it is vital always to keep a check on your company’s income statements and look for red flags having the potential to damage the company’s financial stability.
3. Cash-flow Distortions
As per a U.S. Bank study, 82% of unsuccessful businesses couldn’t manage to survive due to cash flow problems. Here, note that the problems are not limited just to the amount of money debited in or credited from your accounts; the timing of transactions equally matters. As an example, if your accounts are managed based on an invoicing system where your invoices are yet to be paid along with some due loan payments, there might be a possibility of cash flow red flag.
Employing a bookkeeper and utilizing adequate accounting software can help to keep your cash flow managed.
4. Inventory Shrinkage
Though losing a few inventory items during shipping is normal, losing inventory to a massive extent is none other than inventory shrinkage, which is a big red flag indicating fraud. In such a case, an auditor investigates and detects inventory shrinkage by reviewing;
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Balance sheet
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Number of products in stock
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Number of products sold
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Comparing current records with projections and previous records
If required, the auditor can perform an unplanned stock-taking on any random day to detect unwanted characteristics (red flags).
5. Revenue Recognition
This is one of the most common financial frauds. This is often done by overstating revenue through early revenue recognition or recording of sales that have never actually completed. Other than this, a company may understate its income by moving revenue to a later period or representing unorganized records of its completed contracts percentage. Here, red flags can be as follows.
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Reporting increased revenue without a similar growth in cash flow.
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A sudden increase in revenue, typically at the end of the reporting period.
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Revenue statements of consignments for sales, before they are even delivered.
A company maintaining improper revenue recognition may report revenue growth that is way more than the same competitors in the same industry, or it may report increased earnings while its cash flow actually declined.
6. Duplicate Payments
A company’s accountants may erroneously process multiple payments to a vendor for a single order. In case such a mistake is not made intentionally, auditors should identify those or similar errors so that the necessary action can be taken. Apart from that, accountants can make duplicate payments to both actual clients and fake companies. They might even pay (with the intentions to fraud) to companies that don’t even exist.
To prevent this easy-to-do fraud, it is highly recommended to monitor all payments and check for all such red flags, in order to ensure that the payments are going to the intended receivers only.
7. Capitalized Expenses
An expense is stated as a capitalized cost when it is added to the cost of fixed assets on a company’s balance sheet. Capitalized costs are directly related to purchasing fixed assets, for example;
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Costs that can produce benefits which will last beyond the end of the taxable year.
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New assets with useful life of more than one year.
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Costs spent on adding value to the property.
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Getting permits that allow the property to be used for different or more purposes.
It often becomes difficult to find red flags in capitalized expenses. It requires to look for new assets lined on the balance sheet. Suddenly appeared new assets and growth in the same is a red flag; check financial records and find where these assets are being used. Also, make sure your company doesn’t capitalize more than it requires. For instance, it would seem off to see a company capitalizing 100% of its R&D costs. Apart from that, try to adapt to different capitalization policies in the industry.
8. Changes in Accounting Standards
The procedure a company follows to put its numbers together is as necessary as the numbers themselves. The accounting policies a company follows have an impact on these numbers. When your company, in the accounting statements’ notes states that it’s changing accounting policies, there’s a red flag.
However, changes in accounting policies don’t always indicate problems. At times, the change is required as per the FASB (Financial Accounting Standards Board). Therefore, without being concerned about the reason to change, make sure you find out how that change will impact your capability for comparing quarter-to-quarter or year-to-year results.
9. Intangible Assets
There have been instances when companies have presented assets before completely attaining them. This is often called an improper asset valuation which is a common form of profit manipulation. Here are some of the red flags to spot;
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Unexplained or unusual increment in the assets’ book value (receivable, inventory, long term assets).
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Violating GAAP norms in recording expenses as assets.
Another way of representing false assets is asset misappropriation. It involves the theft of assets in small amounts, often perpetrated by a company’s employees. Some ways to present misappropriate assets are mentioned below:
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Theft of intangible assets
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Receipts Embezzlement
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Making a company pay for services or goods that are not even received
Misappropriation is usually done along with misleading or false records of documents in order to prove the assets are missing.
10. Stretching for Yield
With low-interest rates, several companies attempt to attract attention through dividends. This leads some companies to push the mark and offer yields in 10% or a higher range. A few years back, several companies tried to cut their payouts when they started losing cash.
There’s a big red flag when a company has payout ratios exceeding 100% of operating cash flows, and the last resort is to pay dividends using borrowed money. As such companies usually have weaker prospects to improve cash flows which are required to pay back the borrowed money, investors would not show much of interest in them. For example, an investor might not invest in a stock that yields above 7% but will probably face a long-term cash-flow decline.
How to Spot Accounting Red Flags?
As some suggestions are already described above following the problems in accounting, there’s one big solution to detect most red flags – the adoption of useful accounting software.
QuickBooks, FreshBooks, Zoho and Xero are among the top most popular accounting software as per the research conducted by Capterra Inc.
These software can integrate with several apps. It simply means that whatever app you would choose to track expenses, receive payments, send invoices, or do anything for your business accounting purposes, these software would efficiently work with you. For example; you are bound to use an invoice generating tool that you don’t prefer using, but it is suggested by your business partner.
However, with having a customizable accounting software, you can choose a preferred invoicing app that would work best with the software and make your accounting tasks more manageable. Moreover, accounting software help to improve accuracy in accounting while providing an easy-to-use interface to maintain accounts in an organized manner
Conclusion
For business owners, it is advised to keep a vigilant eye on your company’s income statement to spot red flags. Revenues and expenses; both are vulnerable to manipulation. There’s always an incentive for management to engage in manipulation. Thus, it is also recommended to hire an auditor or outsource your accounting process instead of spending your precious time in investigating possible frauds based on red flags.
