Finding Shenanigans

CFA Level 1 - Red Flags

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 fillings

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.