In the concluding chapter on red flags relating to accounting statements, we look at notes to accounts, complex company structure, related party transactions and changes to accounting policy.
Notes to accounts: The financial statements come with schedules and notes to accounts that give a more detailed view and explanation of various policies. If you are investing directly in stocks, then you should be reading the financial statements from start to end. You may not spot any change in the financials in comparison to the previous years, but discover an existing accounting policy you may disagree with.
Unwieldy holding company structure: Some companies have numerous subsidiaries and material joint venture and associate companies. Now, this may all be very normal in that business and by itself is not a red flag. But as an individual investor, you need to gauge if you have the ability to handle that level of complexity. Sometimes, the consolidated financials may look alright but if you go into the numerous subsidiaries, you may find red flags. IL&FS is one example of that.
Related party transactions: Again, this is perfectly legal and can take place for various legitimate purposes. But when the company is dealing with related parties, such as the promoters, then the question does arise if the transactions are on an arms-length basis. Sometimes, these transactions can go on for years without doing anything but one day it could blow up in the face. Lower the level of related-party transactions, in relation to revenue, or to the balance-sheet, the better it is.
Changes to accounting policy: When a company changes an accounting policy and the explanations are not satisfactory, that could be a red flag. A company may decide to report revenue in a single year that was earlier being spread across several years. These changes can take several forms but usually are designed to increase (sometimes even suppress) profits or change the value of assets or liabilities.
In conclusion: These are just some of the red flags one should look for and there will be many more. In sum, anything that seems unusual, any new development, anything that’s not visible elsewhere in the same industry and if the numbers don’t support what the management is saying, then you should be on alert.
There have been many company-related scams that have emerged in the past decade or so, and you should read up on them to know what was done and why they were not unearthed earlier.
Many scams are discovered due to some unrelated event, such as a debt default, insolvency proceedings, due diligence during an acquisition or regulatory investigations. It may be difficult for the average investor to sniff out a scam, but if something looks too good to be true in a company’s financials, it probably is. In the search for alpha, don’t throw caution to the winds.
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