Warning Signals in Notes to the Accounts
This is by no means an exhaustive list, but any one of the signals could mean there is a problem. The more warning signals there are, the higher the risk.
1. Review the section on critical accounting estimates and management judgements, what issues do they raise?
When reviewing the notes to the financial statements, in the section on critical accounting estimates and management judgements, it is important to pay attention to the nature and impact of these estimates and judgements on the company’s financial performance and position. Here are some key things to look for:
- Disclosure: The company should provide full and transparent disclosures about the critical accounting estimates and management judgements used in the preparation of the financial statements. This includes the nature of the estimates and judgements, the assumptions used, and the potential impact on the financial statements.
- Materiality: Assess the materiality of the critical accounting estimates and management judgements on the company’s financial statements. Look for any significant changes in the estimates and judgements that may impact the company’s financial performance and position.
- Reasonableness: Review the reasonableness of the critical accounting estimates and management judgements in light of the available information.
- Consistency: Check for consistency in the critical accounting estimates and management judgements over time.
- Compliance: Review the company’s compliance with accounting standards and regulations related to the critical accounting estimates and management judgements.
- Risk management: Understand the company’s processes for identifying, measuring, monitoring and controlling the risks associated with the critical accounting estimates and management judgements.
2. Are there contingent liabilities?
Contingent liabilities are potential financial obligations or liabilities that a company may be responsible for in the future, but that are not currently recorded on the company’s balance sheet. These types of liabilities may arise from events such as lawsuits, guarantees, or other agreements that the company has made. The likelihood and amount of a contingent liability is uncertain and may depend on the outcome of future events.
Examples of contingent liabilities include:
- pending lawsuits or legal settlements
- product warranty claims
- guarantees on debt issued by other companies
- environmental clean-up costs
- leases with uncertain termination costs
- potential losses from derivatives contracts
It’s important for investors to be aware of the company’s contingent liabilities and to assess the potential impact they may have on the company’s financial performance and position. Companies are required to disclose the nature and estimated amount of any significant contingent liabilities in the notes to their financial statements. It’s also important to monitor any changes in the company’s contingent liabilities and to understand the company’s processes for managing and mitigating these risks.
3. Are there related party transactions, which could result in losses?
Related party transactions refer to any business or financial transactions that occur between a company and another party with which it has a close relationship, such as its affiliates, directors, officers, or significant shareholders. These types of transactions can include things like sales or purchases of goods or services, loans, investments, or other financial arrangements. These transactions can raise concerns because the parties involved may have conflicting interests, and the terms of the transactions may not be as favorable to the company as if they were negotiated with an unrelated third party. Additionally, related party transactions may not be fully disclosed or may be presented in a way that makes them difficult for investors to understand.
Related party transactions can raise several concerns:
- Conflict of interest: Related party transactions may create conflicts of interest for the company and its management, as they may not act in the best interest of the company and its shareholders.
- Lack of arm’s-length negotiation: Related party transactions may not be conducted on an arm’s-length basis, meaning that the terms of the transactions may not be as favorable to the company as if they were negotiated with an unrelated third party.
- Lack of transparency: Related party transactions may not be fully disclosed or may be presented in a way that makes them difficult to understand, which can make it difficult for investors and other stakeholders to assess the impact of the transactions on the company’s financial performance and position.
- Misuse of assets: Related party transactions may allow a company’s assets to be used for the benefit of related parties rather than the company itself.
- Materiality: Related party transactions should be disclosed if they are material to the company’s financial statements.
- Compliance: Related party transactions should comply with laws, regulations and accounting standards.
4. Are there exposures to financial derivative transactions which could cause significant losses?
When reviewing financial statements that include exposures to financial derivative transactions that could cause significant losses, it is important to pay attention to the nature and impact of these exposures. Specifically, you should review the notes to the financial statements that explain the types of derivative transactions the company is involved in, the risks associated with these transactions, and the measures the company is taking to manage these risks. Additionally, here are some key things to look for:
- Counterparty risk: The company should have policies and procedures in place to manage the risk of loss due to the default of a counterparty. (Types of Financial Risk to be Disclosed)
- Valuation: The company should have appropriate procedures in place to value its derivatives at fair value and to ensure that the accounting for these derivatives is accurate. (Level of fair values of financial instruments (Level 1, Level 2 and Level 3))
- Hedging effectiveness: The company should have an effective hedge accounting program in place to ensure that the derivatives are being used to effectively hedge underlying exposures. (Financial Derivatives and Hedging)
- Risk management: The company should have a risk management program in place to ensure that it is able to identify, measure, monitor, and control its exposure to derivative transactions.
- Materiality: The exposures to financial derivatives should be material to the company’s financial statements.
- Disclosures: The company should provide full and transparent disclosures about the exposures to financial derivatives, including the nature, terms, and fair value of the derivatives, as well as the risks and accounting policies associated with them.
It’s also important to understand the company’s internal controls and financial reporting processes to ensure that they are adequate to support the accurate and timely recognition of the exposures to financial derivative transactions. Additionally, it’s important to evaluate management’s ability to identify and correct errors in a timely manner and to assess whether the exposures to financial derivatives are consistent with the company’s overall risk management strategy.
5. Are there any voluntary or required changes in accounting policies that have positively impacted earnings or net assets?
As a retail investor, when reviewing financial statements that include voluntary or required changes in accounting policies that have positively impacted earnings or net assets, it is important to pay attention to the nature and impact of these changes. Here are some key things to look for:
- Compliance with GAAP or IFRS: The changes in accounting policies should be in compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). You can look for the company’s financial statements to include a statement of compliance with GAAP or IFRS.
- Consistency: The company should consistently apply the same accounting policies across different periods and different types of transactions. Look for any changes in the company’s accounting policies and the reasons for those changes.
- Relevance: The accounting policies should be relevant to the specific industry and business activities of the company. Compare the company’s accounting policies to industry standards and best practices.
- Reliability: The accounting policies should be based on accurate and reliable information, and should be able to be independently verified. Look for any red flags such as misstated income or discrepancies in the financial statements.
- Materiality: The accounting policies should be able to recognize income that is material to the company’s financial statements. Look for any significant changes in the company’s income or profitability that may be due to a change in the accounting policies.
- Timing: it’s important to check whether the changes in accounting policies had a material impact on the financial performance and position of the company, or whether they are immaterial.
6. Is the income recognition policy appropriate?
As a retail investor, you can determine if a company’s income recognition policy is appropriate by reviewing the company’s financial statements and related notes, as well as its annual report and other SEC filings. However, it’s worth noting that evaluating a company’s income recognition policy can be complex and may require a certain level of financial literacy. Here are some key things to look for:
- Compliance with GAAP or IFRS: Income recognition policies should be in compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). You can look for the company’s financial statements to include a statement of compliance with GAAP or IFRS.
- Consistency: The company should consistently apply the same income recognition policy across different periods and different types of transactions. Look for any changes in the company’s income recognition policy and the reasons for those changes.
- Relevance: The income recognition policy should be relevant to the specific industry and business activities of the company. Compare the company’s income recognition policy to industry standards and best practices.
- Reliability: The income recognition policy should be based on accurate and reliable information, and should be able to be independently verified. Look for any red flags such as misstated income or discrepancies in the financial statements.
- Materiality: The income recognition policy should be able to recognize income that is material to the company’s financial statements. Look for any significant changes in the company’s income or profitability that may be due to a change in the income recognition policy.
7. Have there been any restatements due to errors in accounts in previous periods?
When reviewing financial statements that have been restated due to errors in accounts from previous periods, it is important to pay attention to the nature and impact of the errors. Specifically, you should review the notes to the financial statements that explain the reasons for the restatements and the impact they have on the previously reported financial information. Additionally, it is important to evaluate the effectiveness of the company’s internal controls and financial reporting processes, as well as management’s ability to identify and correct errors in a timely manner. It’s also important to check whether the restatements have a material impact on the financial performance and position of the company, or whether they are immaterial.
There are many different types of restatements that a company may make to its financial statements, but some of the most common include:
- Revenue recognition errors: These occur when a company recognizes revenue at the wrong time or in the wrong amount.
- Inventory errors: These occur when a company misstates the value or quantity of its inventory.
- Accounts payable and receivable errors: These occur when a company misstates the amount or timing of payments it owes or is owed.
- Asset impairment errors: These occur when a company does not properly assess the impairment of an asset.
- Lease accounting errors: These occur when a company does not properly account for leases under the new accounting standards.
- Tax errors: These occur when a company does not properly account for taxes or does not have accurate estimates of its tax liabilities.
- Pension and other post-employment benefit errors: These occur when a company does not properly account for pension plans and other post-employment benefits.
- Merger and acquisition errors: These occur when a company does not properly account for the assets and liabilities of a company it has acquired.