Accounting Gimmicks & Spotting Red flags

 Below are several accounting gimmicks and red-flag signals that a diligent investor can spot by examining a company’s last three years of financial statements and carefully reading the notes to accounts -

1. Continuous decline in revenues for more than three years.
2. Inflating revenues by recognizing them prematurely, such as before actual shipment; recording bogus revenues; or classifying one-time asset sale gains as revenues.
3. Significant and rising amount of non-operating income relative to industry peers over a prolonged period.
4. Regular recurrence of non-recurring or one-time expenses.
5. Increase in capital expenditure without a corresponding increase in sales, suggesting the company might be capitalizing normal operating expenses.
6. Poor or irregular cash flow over an extended period.
7. Cash flow remains negative for a long time, which may indicate depletion of cash reserves and potential financial trouble, especially in the absence of new equity investors or lenders.
8. Operating cash flow consistently lags behind the company’s net income or net profit for a prolonged duration.
9. Increasing operating cash flows by deliberately delaying payments to suppliers. This can often be identified through a significant increase in payables on the balance sheet.
10. Abnormal difference between the growth rates of operating cash flow and earnings.
11. Debt-to-equity ratio rising at an alarming rate; this often suggests the company is taking on more debt than its operations can sustainably handle.
12. Continuous decline in the interest coverage ratio over 2–3 years, indicating reduced ability to service debt and increased financial risk.
13. Continuous downtrend in gross profit margin for more than three years, indicating underlying issues beyond normal cyclical effects.
14. Abnormal increase in accounts receivable relative to sales, suggesting customers are delaying payments or defaulting.
15. Abnormal growth in inventories compared to sales, indicating poor inventory management or weak product demand.
16. Significant third-party transactions that require scrutiny.
17. Earnings smoothing by overstating or understating expenses and revenues, especially to maintain stable profitability during low-profit periods.
18. Frequent boosting of profits through large one-time gains, such as asset sales.
19. Inconsistencies between the company’s financial statements and management’s statements about its current condition.
20. Significant bank accounts, subsidiaries, or branches located in tax haven jurisdictions without clear business justifications.
21. Companies showing good liquidity and solvency metrics but failing to meet loan obligations on time.
22. Significantly higher compensation paid to promoters or management compared to industry peers or standards.
23. Frequent disagreements or differences in views between management and external auditors.