All Red Flags of Creative Accounting in Financial Statements

Creative accounting refers to the practice of using accounting techniques to present financial statements in a way that may favour the company’s image, but does not reflect its true financial health. While these methods may stay within legal accounting standards, they often mislead investors, regulators, and other stakeholders by hiding risks or exaggerating performance.

In today’s business environment, where financial information drives investment and lending decisions, the ability to spot creative accounting practices is an essential skill for analysts, auditors, and investors. Recognizing early warning signs, or red flags, in financial statements can help prevent poor decisions, reduce exposure to fraud, and ensure a clearer understanding of a company’s real financial position.

Assets top out balance sheet construction. Like liabilities, assets are divided into two categories: current assets, which are those that will be sold within 12 months, and long-term assets, which will be owned and used for more than one year. Items commonly found in the asset category include: cash and equivalents, accounts receivable, inventory, and intellectual intangibles.

Provision for Doubtful Accounts

Accounts receivable (AR) have a direct link to revenues on the income statement. Companies that use accrual accounting can book revenue in accounts receivable as soon as a sale is made. Thus, the processing of accounts receivable can be one high-risk area for premature or fabricated revenues.

AR may be overstated because of inappropriate planning for doubtful accounts. Prudent companies typically take proactive measures for AR defaults. By not doing so, this can inflate earnings. It is up to each company to estimate the percentage of accounts receivables that regularly go uncollected. If there is no allowance for doubtful accounts, AR will receive a temporary boost in the short term.

Investors may detect when the reserves for doubtful accounts are inadequate. AR will not be fully turned into cash, which can show up in liquidity ratios like the quick ratio. Write-downs will also need to be made to revenues. If accounts receivable up a substantial portion of assets and inadequate default procedures are in place this can be a problem. Without doubtful account planning, revenue growth will be overstated in the short term but potentially retracted over the longer term.

Revenue Acceleration

In the asset category, companies can also overstate revenues through acceleration. This could come from booking multiple years of revenue at once. Companies may also manipulate revenues by comprehensively booking a recurring revenue stream upfront rather than spreading it out as it is expected to be received. Revenue acceleration is not necessarily illegal but it is not usually a best practice.

Inventory Manipulation

Inventory represents the value of goods manufactured but not yet sold. It is usually valued at wholesale and sold with a markup. When inventory is sold, the wholesale value is transferred over to the income statement as the cost of goods sold (COGS), and the total value is recognized as revenue. Overstating any inventory values could lead to an overstated COGS, which can reduce the revenue earned per unit.

Some companies may look to overstate inventory to inflate their balance sheet assets for the potential use of collateral if they need debt financing. It is typically a best practice to buy inventory at the lowest possible cost to reap the greatest profit from a sale.

Laribee Wire Manufacturing manipulated inventory by recording phantom inventory and carrying other inventory at bloated values. This helped the company borrow $130 million from six banks by using the inventory as collateral. Meanwhile, the company reported $3 million in net income for the period, when it lost $6.5 million.

Investors can detect overvalued inventory by looking for telling trends like large spikes in inventory values. The gross profit ratio can also be helpful if it is seen to fall unexpectedly or to be far below industry expectations. This means net revenues may be falling or extremely low because of excessive inventory expensing. Other red flags may include:

• Higher inventory levels than sales
• Higher inventory levels than total assets
• A decrease in inventory turnover
• An increase in the cost of sales as a percentage of sales.

Undervaluing liabilities is a second way to manipulate financial statement reporting from the balance sheet. Any understatement of a company’s expenses can be beneficial in boosting bottom line profits.

Contingent Liabilities

Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee, or the date payable. For example, warranty obligations or anticipated litigation losses may be considered contingent liabilities.

Companies can creatively account for these liabilities by underestimating them or downplaying their materiality.

Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income and shareholders' equity.

Investors can watch for these liabilities by understanding the business and carefully reading a company's footnotes, which contain information about these obligations. For instance, pending lawsuits are contingent liabilities. That's because there is no guarantee about the outcome. This should be disclosed when earnings reports and financial statements are released.

Other Expenses

Some other ways companies may manipulate expenses can include: delaying them inappropriately, adjusting expenses around the time of an acquisition or merger, or potentially overstating contingent liabilities to adjust them in the future as an increase to assets. Moreover, subsidiary entities as mentioned above, can also be a haven for off-balance sheet reporting of some expenses that are not transparently realized.

Shareholders’ equity consists of the value of stocks, any additional paid-in capital, and retained earnings, which are carried over from net income on the balance sheet. If a company overstates assets or understates liabilities it will result in an overstated net income, which carries over to the balance sheet as retained earnings and therefore inflates shareholders’ equity.

Shareholders’ equity is used in several key ratios that may be assessed by financial stakeholders when evaluating a company as well as for maintaining current financing arrangements such as credit lines.

Some of these ratios may include debt to equity, total assets to equity, and total liabilities to equity. It is also used to calculate return on equity (ROE), which is central to evaluating the overall balance sheet performance of a company as well as the performance of management. ROE is the result of net income over shareholders’ equity.

1. Protects Investors and Lenders
   Helps avoid investing or lending money to companies that are hiding poor performance.
2. Improves Decision-Making
   Gives analysts, auditors, and managers a clearer picture of the true financial health of a company.
3. Reduces Risk of Fraud
   Early detection of suspicious accounting practices lowers the risk of financial scandals.
4. Ensures Transparency
   Encourages companies to maintain honest reporting, improving trust with stakeholders.
5. Safeguards Reputation
   Auditors, analysts, and investors who spot red flags maintain their professional credibility.
6. Supports Regulators and Compliance
   Helps enforcement agencies detect violations of accounting standards and prevent corporate collapses.
7. Protects the Economy
   By identifying problems early, it prevents large-scale failures that could hurt jobs, investors, and markets.