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When it comes to analysing financial statements and accounts, as forensic accountants we can help with identifying potential irregularities and uncovering financial misconduct. We have come to recognise some red flags that may indicate underlying issues within a company’s accounts. We have compiled our top 10 red flags.
1. Audit opinion
When looking for potential red flags in Statutory accounts it is often useful to check if they are audited or not.
If accounts are audited looking at the audit opinion could highlight potential red flags. An audit opinion can be unqualified/unmodified or modified. If a report has a modified opinion there are three possible types of modification, these are: Qualified, Adverse, and ‘Disclaimer’ of opinion.
- Qualified audit opinion – This means that there is a material but not pervasive misstatement. Not pervasive means that the matter is isolated to a specific part of the financial statements. If the misstatement is isolated to one area, this is not pervasive and therefore some reliance can be placed on the financial statements. This is the ‘best’ modified opinion.
- Adverse Opinion – This is where a misstatement impacts multiple areas of the accounts. If there is an adverse opinion the accounts cannot be relied upon by users. This is known as a material and pervasive misstatement.
- Disclaimer of Opinion – A disclaimer of opinion means that the auditor was unable to obtain sufficient and appropriate audit evidence and that those items that cannot be accessed could be materially misstated and pervasive.
2. Overdue accounts
Companies have 9 months from year-end to file with Companies House. An overdue audited set of accounts could imply issues with the audit, or with going concern.
3. Restated accounts
While accounts being restated could have an innocent and simple explanation to it, it is worth considering the reason for the original misstatement and subsequent misstatement. For example, have things been recognised when they shouldn’t have? Or was there a disagreement over the application of accounting policies?
4. Unusual expense and revenue patterns
A primary red flag within accounts is to do with unusual or inconsistent revenue patterns or fluctuations that cannot be explained by external factors or changes within the market. This may include sudden spikes or declines in revenue, irregularities in the timing of revenue recognition, or unexplained changes in the sales mix.
Similarly, expenses can show up red flags in things such as increases in expense categories, unusually high overheads or unusual timing.
5. Contingent liabilities
A contingent liability is a possible obligation depending on whether some uncertain future event occurs or a present obligation, but payment is not probable, or the amount cannot be reliably measured. An uncertain liability would not be recognised in the balance sheet as a liability but would instead simply be included in the notes of the accounts. The note would disclose a brief description of the nature, timing, and uncertainties of the liability unless the possibility of economic outflow (i.e. having to make a payment) is remote.
6. Post balance sheet events
All post-balance sheet events should be disclosed in a note in the financial statements. There are two types of post-balance sheet events.
- An adjusting event which is one where the condition existed at the balance sheet date – This could be the settlement of a court case after the balance sheet date which confirms that the entity had a present obligation at that balance sheet date.
- A non-adjusting event. This is one where the conditions arose after the balance sheet date – This could be a decline in the Market value of investments or natural disasters such as a volcano eruption or fire. If there was no indication that the events would occur at the balance sheet date this would be a non-adjusting event.
7. Changes to gross profit margin
Dramatic changes to gross profit margins (gross profits divided by sales) could imply stock manipulation. This could range from poor stock management where high levels of stock are being written off due to stock misappropriation, to a stock build-up in the balance sheet where stock is being reported as having a value but is unsellable.
8. Significant other income
This is often where account manipulation is hidden. There have been cases where fictitious journals have been created which increased other income and fixed assets. This can be a place to hide manipulation as the increase in other income does not impact the gross profit and as a result, could be less noticeable.
9. Unusual transactions and related party dealings
Unusual transactions can include large one-time transactions, complex structures, or non-arm’s-length dealings with related entities. These sorts of transactions can potentially be used to manipulate financial results or inflate revenue.
10. Payment of unlawful dividends
If a dividend is paid where there are not sufficient reserves in the balance sheet, then this is an unlawful dividend. Dividends paid in one period can lawfully exceed the profits after tax made in that year provided that the company has sufficient brought forward reserves.
Whilst a lot of these potential red flags could have potentially straightforward explanations, they do need to be investigated, understood and checked. If you think you have some potential red flags in your business, speak with a solicitor in the first instance, but the forensic accounting team here at Henderson Loggie will be happy to discuss the next steps with you.