Red Flags in the Analysis of Balance Sheets

By Colleen S. Vallen
Special to the Legal

A financial statement is a record of the financial activities of a business. Attorneys often find themselves in situations that require them to be able to ask questions about, discuss and explain financial statements.

Financial statements typically include the income statement, balance sheet, statement of cash flows and statement of retained earnings. In a previous post, I discussed examples of red flags that can be identified on an income statement . In this post, I focus on sample red flags that can be identified on the balance sheet.

Red flags are circumstances that are unusual in nature or deviate from customary activity. Being able to identify and understand red flags allows the attorney to ask questions about the situation. Some red flags will have an explanation, while others may be indicative of a business problem such as mistakes, errors or omissions in the financial data or, in some cases, fraud. The information obtained from asking questions can provide valuable data about the business.

The balance sheet provides information about a business’ assets, liabilities and shareholders’ equity. The balance sheet reflects a specific point in time. Comparing balance sheets for multiple periods and analyzing the overall changes as well as account-specific changes can identify red flags. Unexpected or unusual changes in the balance sheets need to be further analyzed. Below, I discuss the balance sheet item – accounts receivable – and the questions that should be considered when unexpected or unusual changes in this account have been identified.

Accounts receivable is found on the balance sheet under current assets. From a business perspective, accounts receivable should ultimately be converted to cash as part of the business’ normal operations.

Accounts receivable is money a business is owed by its customers (i.e., goods and/or services were provided by the business, but the business has not yet been paid). When evaluating accounts receivable, you should consider changes between periods as well as the relationship between accounts receivable and sales. One specific red flag to be aware of is a large upward change in accounts receivable. Areas for questioning include:

• What is driving the change in receivable?
• Is there a valid reason for the increase or could it be an indicator of a business problem?
• Does the business age its receivables – categorizing receivables by how long they have been outstanding? If an aging is prepared, are the receivables in the older categories growing?
• What is the business’ credit policy and how does the policy relate to what is actually happening with the accounts receivable?
• What is the business’s write off policy for uncollectible accounts receivable?
• Are write-offs increasing?

The analysis of accounts receivable can identify cash-collection issues that can significantly impact a business. The inability to turn the sale of goods or provision of services into cash can inhibit a business’ ability to pay its bills, to fund growth, etc. In addition, changes in accounts receivable can be a red flag of fraudulent activity, including embezzlement and fraudulent financial reporting schemes.

When analyzing the balance sheet across multiple periods, identify trends and changes in performance not just for the accounts receivable, but for all accounts. It is also helpful to consider balance sheet red flags with other financial data analysis such as income statement red flags. Use this analysis to ask questions about the business’ performance and how these changes will impact it. Having the knowledge to decipher changes to financial performance will provide the attorney with a better understanding of where the business has been and where it is going, as well as highlighting potential financial problems that need to be considered.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents, as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at cvallen@citrincooperman.com or 215-545-4800.

 

Comments

[Julie J. Woods]

Thanks for sharing this incredible knowledge. I learned something different and useful today. Thanks so much! www.flagmartusa.com