Introduction
In December 2020, General Electric agreed to pay a $200 million penalty to settle Securities and Exchange Commission (SEC) charges that it had misled investors about its power and insurance businesses. Much of what the SEC described had left traces in the company's own figures. GE's industrial cash flow had been boosted by selling receivables internally to its finance arm, GE Capital, which pulled forward cash that would otherwise have arrived in later years. A large share of its power profits in 2016 and 2017 came from reducing cost estimates on existing service contracts. And it had lowered its projections of future insurance claims costs while long-term care claims were rising, as the SEC's announcement of the settlement explains.
None of these practices was hidden in the sense of being absent from the accounts. Each was a pattern that analysts could see, or ask about: cash flow rising faster than profits for reasons other than operations, profits supported by changes in estimates, reserves moving against the trend in claims. That is what accounting red flags are. They are not proof of wrongdoing, and most have innocent explanations. They are the patterns that tell an analyst where to look harder.
Revenue Red Flags
Revenue is the largest number in most income statements and the one most often managed, because small changes in timing move growth rates that investors watch closely.
The most reliable signal is receivables growing faster than revenue. If customers are taking longer to pay, or the company is recognizing revenue before it has a firm claim to payment, receivables rise relative to sales. Days sales outstanding, receivables divided by revenue times the number of days in the period, turns that into a trend. A sustained rise deserves an explanation: a shift toward slower-paying customers, longer payment terms offered to win business, or revenue recorded too early. Growing unbilled receivables and contract assets, which represent revenue recognized but not yet invoiced, deserve the same attention, as described in accounts receivable and credit losses.
- Days sales outstanding
Accounts receivable divided by revenue, multiplied by the number of days in the period, usually 365 for a year or about 91 for a quarter. It estimates how long customers take on average to pay, and a rising trend can signal looser credit terms, collection problems or revenue recognized before it was earned.
Pulling Revenue Forward
Timing can also be managed without breaking the recognition rules. Under Armour settled SEC charges in 2021 for $9 million after the agency found that, from the third quarter of 2015, it had pulled forward about $408 million of orders that customers had asked to be shipped later, to meet analysts' revenue estimates, without telling investors how much of its growth came from doing so. The sales themselves were not alleged to breach accounting rules; the problem was the undisclosed effect on growth. Signs of the practice include revenue concentrated at quarter ends, rising receivables and inventory at customers, and growth that slows sharply once the pulling forward stops. For companies selling through distributors, rising channel inventory, sometimes disclosed as weeks of supply, is the equivalent signal.
Other revenue signals include changes in revenue recognition policies, a growing share of revenue from related parties, bill-and-hold arrangements and, in subscription businesses, deferred revenue that falls while reported revenue rises, which can mean customers are paying in advance less than before.
Expense and Reserve Red Flags
Profits can also be raised by reducing expenses that rest on judgment. The patterns are well known:
- Capitalized costs rising faster than the business, such as software development, customer acquisition or interest costs added to assets rather than expensed.
- Longer depreciation lives or higher salvage values, which lower annual depreciation without any change in the assets.
- Reserves falling as a share of the items they cover: allowances for credit losses relative to receivables, warranty reserves relative to sales, inventory reserves relative to inventory.
- Inventory growing faster than cost of sales, which may signal products that are not selling and write-downs to come.
- Favorable changes in estimates, such as lower cost estimates on long-term contracts or more optimistic pension assumptions, that add to profit in the period they are made.
GE's power business illustrates the last point: reducing the estimated costs of fulfilling existing long-term service agreements increased their profitability and flowed straight into earnings. Changes in estimates are legitimate and required when circumstances change, but a pattern of favorable changes in periods when the underlying business is weakening is a classic warning sign. A reserve that is built up in good years and released in bad ones, sometimes called a cookie jar reserve, smooths earnings in a way that hides the real trend. Depreciation lives deserve the same scrutiny: an extension disclosed as a change in estimate, of the kind discussed in useful lives and salvage value, can add materially to operating income in a single year.
Cash Flow Red Flags
Cash flow is harder to manipulate than earnings, which is why analysts rely on it, but it is not immune. The first test is the relationship between operating cash flow and net income over several years. Earnings that persistently exceed operating cash flow suggest accruals that may not turn into cash.
The subtler problem is operating cash flow inflated by financing. Selling receivables to a factor brings cash in earlier and records it as operating cash flow, while the company may retain some of the risk; selling them to a captive finance arm, as GE did, has the same effect on a cash flow figure reported for the industrial business alone. Supplier finance programs, in which a bank pays the company's suppliers early and the company pays the bank later, let a company stretch its payment terms and raise operating cash flow without any change in operations; buyers must now disclose the key terms of these programs and the amounts outstanding under them, under Accounting Standards Codification (ASC) 405-50. Classification matters too: costs capitalized as investments leave operating cash flow and appear in investing, which flatters operating cash flow and free cash flow definitions that ignore part of capital spending. The reconciliation explained in cash flow from operations is where these effects show up.
Disclosure and Governance Red Flags
Some of the most important signals are outside the numbers. An auditor's resignation is rare and serious. In October 2024, Ernst & Young resigned as auditor of Super Micro Computer, saying it was unwilling to be associated with the financial statements prepared by management; the company disagreed, a special committee of its board later reported that the evidence it reviewed raised no substantial concerns about the integrity of senior management or the audit committee, and Super Micro appointed BDO as its new auditor and filed its delayed annual report the following year, as its annual report for that period describes. Whatever the eventual findings, a resignation of that kind changes the questions any banker or investor has to ask.
Other governance signals include late filings, disclosures of material weaknesses in internal control, frequent changes of chief financial officer or auditor, restatements, frequent redefinitions of segments or of non-GAAP measures (figures that depart from generally accepted accounting principles), related-party transactions and compensation tied closely to metrics that management can influence through accounting choices. A widening gap between reported and adjusted earnings, or add-backs that recur every year, is a related signal, examined in non-GAAP measures. The ways restatements and changes in accounting are reported are covered in restatements and accounting changes.
A Checklist
Most of these signals come down to a ratio tracked over several periods or a disclosure read closely, and the table pairs each red flag with what to calculate or read and what it may signal:
| Red flag | What to calculate or read | What it may signal |
|---|---|---|
| Receivables outgrowing revenue | Days sales outstanding over several periods | Early recognition, looser terms, collection problems |
| Inventory outgrowing cost of sales | Days inventory outstanding, inventory reserves | Slow-moving stock, future write-downs |
| Falling reserves | Allowances, warranty and other reserves as a share of their base | Earnings supported by reserve releases |
| Rising capitalized costs | Capitalized costs relative to revenue and to expensed costs | Costs moved off the income statement |
| Earnings above cash flow | Operating cash flow to net income over three to five years | Accruals that may not convert to cash |
| Cash flow from financing operations | Factoring, securitization and supplier finance disclosures | Operating cash flow pulled forward |
| Favorable estimate changes | Disclosures of changes in estimates and their effect | Profits from assumptions rather than operations |
| Auditor or finance team changes | Auditor reports, 8-K filings, management changes | Disagreements over accounting or controls |
How Bankers Use Red Flags
In due diligence, red flags become questions for management and for the accountants preparing a quality of earnings report: why receivables days rose, what drove the release of a reserve, how much of operating cash flow came from factoring. In pitching and valuation, they decide which figures can be relied on and which need adjusting. In equity and debt offerings, they shape the disclosure the underwriters will insist on and the comfort they will seek from the auditors.
Short sellers and investigative researchers use the same toolkit, often publishing reports that set out a series of red flags at once. Bankers working on a deal for a company that has been the subject of such a report need to understand each allegation, how the company has responded and what the evidence in the accounts actually shows, because buyers, lenders and regulators will ask the same questions.
