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Red Flags in Assessing Earnings Quality

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One step in assessing the quality of earnings is to look for red flags. An example of a red flag is a change in auditors. A parting of the ways with auditors may be because of disagreements over accounting matters. This will be filed in an 8-K report. List five other red flags the astute analyst might look for, describe why it is a red flag, and identify where the analyst might find this information.

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Solution Summary

How to recognize and explain red flags in Asset Evaluation. Red flags include: sales recognition and timing, claiming sales that have not occurred, suspicious reporting of expenses and other liabilities, inadequate disclosures and exaggerated asset value. Each of these red flags are explained.

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1. Sales recognition and timing
This is a red flag if it is abnormal. Over stated sales could mean the hiding of expenses. The analyst would find this information in comparison of previous year Sales records. The red flag would be a GAAP violation by early recording of sales. This can be found in many returns accompanied by increases of credits.

2. Claiming Sales that have not ...

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