When analyzing a company's SEC filings like 10-Ks and 10-Qs, there are certain red flags investors should keep an eye out for. Though a filing may seem fine on the surface, there could be hints of problems or risks buried in the details. Here are some key warning signs to watch out for:
Revenue Recognition Changes
Sudden changes in how the company recognizes revenue can be a major red flag. If they switch from an easier method like cash-basis to a more stringent accrual method, it could be to hide slowing growth. Complex criteria for recognizing revenue like percentage-of-completion for long term projects can also make results hard to decipher.
Overly Optimistic Forward Guidance
Companies have gotten in trouble for providing financial guidance way above their realistic potential. This is usually an attempt to keep investors happy when the business is actually headed for a downturn. Analyze the assumptions underlying the projections to see if the goals are achievable or based on wishful thinking.
Deferred Tax Asset Increases
A growing deferred tax asset account might indicate that the company is incurring net operating losses for tax purposes. This essentially represents future potential tax savings from current period losses. Rapid increases in deferred tax assets can suggest there are major business troubles reducing profitability.
Unusual Auditor Comments
Read the auditor’s opinion carefully for any modifications or warnings about finances, fraud risks, going concern matters, or ability to stay in business. Adverse opinions are very serious red flags. But even subtle wording changes year-over-year can suggest auditors have uncovered problems behind the scenes.
Related Party Transaction Details
Many dubious dealings hide in opaque disclosures about transactions with related parties or unconsolidated entities. Look for evidence of conflicts of interest, special purpose vehicles to take on risky assets, and shell companies that could conceal financial engineering or fraud.
Buried Related Party Disclosures
Companies will often disclose related party transactions in the middle of a lengthy financial filing, hoping investors don't notice. Read all footnotes carefully and watch for evidence that executives are self-dealing or have conflicts of interest in dealings with the company. For example, an acquisition of another company that a CEO has a stake in could be a ploy to benefit themselves.
Shifting Performance Metrics
When companies define unusual, non-GAAP metrics like "adjusted EBITDA" or change metrics between periods, it demands scrutiny. They may be attempting to distract from declining business fundamentals through cherry-picked, alternative performance evaluations that paint a misleading picture. Shifting metrics is often a technique to hide deterioration.
If a company suddenly fires its auditor or the auditor resigns before completing their assignment, find out why. This can signal that the auditor uncovered misbehavior or financial errors that the company wants to conceal. At a minimum, a change in auditors led to reporting delays while getting the new firm familiarized in a short time window.
Inventory Accounting Method Changes
While methods like LIFO and FIFO are acceptable accounting alternatives, flip-flopping inventory valuation methods can make trend analysis challenging for investors. It also allows companies to time method changes to give income statements an artificial boost in the short term when needed, so beware inconsistency.
These subtler red flags demonstrate why studying SEC filings line-by-line is so important. Obscure accounting policy shifts or hard-to-understand related party deals announced with little fanfare can dramatically impact shareholder value. The devil truly is in the details with SEC filings. Train your eye to look past the slick financial presentations and upbeat language. Understanding regulatory filing red flags can help reveal when real risks exist underneath a company’s surface.
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