Forensic risk and red flags

Forensic accounting looks at the financial statements not for what they say, but for what they hide. Forensic risk is the chance that the headline numbers are materially misleading - through aggressive accounting, hidden related-party transactions, off-balance-sheet exposure, or outright fraud.

The five most common forensic red flags

1. Revenue growth without cash inflow growth. Revenue up 20%, CFO flat. Either the company is selling on extended credit (working-capital risk) or recognising revenue prematurely (accounting risk).

2. Earnings without earnings-quality. PAT growing, CFO/PAT ratio steadily falling below 0.7 over 5 years. Real cash is not arriving.

3. Off-balance-sheet liabilities. Contingent liabilities (disputed tax, pending litigation, guarantees to subsidiaries) growing faster than equity. Eventually they may crystallise - and the balance sheet will be much worse than reported.

4. Aggressive capitalisation. Routine maintenance expenses being capitalised onto the balance sheet to flatter current-period profit. Look at the gap between maintenance capex and growth capex management discloses.