Common Mistakes and Red Flags When Reading Financial Statements

How to Use This Chapter

This chapter is a field guide to spotting common mistakes (often unintentional) and red flags (patterns that may indicate aggressive accounting, weak controls, or operational stress). Each category below lists (1) observable symptoms you can see in the statements, (2) follow-up questions to narrow the cause, and (3) what to request or compute to confirm.

Category 1: Revenue Quality Red Flags

1) Unusual revenue spikes (especially near period-end)

Observable symptoms

• Revenue jumps sharply vs prior periods without a matching operational explanation (headcount, customers, capacity, marketing spend).
• Spike concentrated in the last week/month/quarter.
• Large increase in credit sales while cash receipts lag.

Follow-up questions

• What changed operationally (pricing, new channel, contract wins, promotions)?
• Were any large deals booked with special terms (extended payment, right of return, acceptance clauses)?
• Any manual journal entries to revenue at period-end?

Confirm with

• Sales by day/week and by customer; top-10 customer concentration report.
• Invoice listing around period-end; shipping/fulfillment logs; contract start dates.
• Credit memo/returns report in the following period (look for “reversal” behavior).

2) Accounts receivable (AR) growing faster than revenue

Observable symptoms

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• AR balance increases materially while revenue is flat or modestly up.
• Collections appear slower (more past-due invoices).
• Bad debt expense or allowance does not rise despite older receivables.

Follow-up questions

• Did payment terms change (Net 30 to Net 60/90)?
• Are you billing earlier (milestones, upfront invoices) than delivery/acceptance?
• Any disputes, chargebacks, or customer financial trouble?

Confirm with

• AR aging (current, 1–30, 31–60, 61–90, 90+ days) and trend over time.
• Cash receipts vs billings schedule; write-off history.
• Allowance for doubtful accounts policy and calculation.

3) Heavy discounts, returns, or allowances masking “headline” revenue

Observable symptoms

• Gross sales look strong, but net sales lag due to discounts/returns.
• Returns spike after promotional periods.
• Revenue is stable but gross margin deteriorates due to discounting.

Follow-up questions

• Are discounts strategic (new market entry) or reactive (inventory clearing, churn prevention)?
• Are returns due to quality issues, wrong shipments, or buyer’s remorse?
• How are returns estimated and recorded (reserve vs when incurred)?

Confirm with

• Discount rate by product/customer; return rate by cohort (month of sale).
• Credit memo report; returns authorization logs; warranty/defect tracking.
• Revenue recognition policy for variable consideration (discounts, rebates, returns).

Category 2: Margin Issues (COGS and Cost Capitalization)

1) “COGS creep” (costs rising quietly while revenue looks fine)

Observable symptoms

• Gross margin declines gradually over several periods.
• COGS increases faster than units shipped or service hours delivered.
• Freight, subcontractors, or materials costs rise without price increases.

Follow-up questions

• Did supplier prices increase? Did you lose volume discounts?
• Are you using more expedited shipping, overtime, or higher-cost labor?
• Any product mix shift toward lower-margin items?

Confirm with

• COGS breakdown (materials, labor, freight, subcontractors) by period.
• Unit economics by SKU/service line; vendor price trend report.
• Inventory costing method and any changes (e.g., standard cost updates).

2) Inconsistent capitalization of costs (moving expenses to the balance sheet)

Observable symptoms

• Sudden improvement in profit without a clear operational change.
• Increase in fixed assets or “capitalized software/development” while related expenses drop.
• Depreciation/amortization rises later, after a “good” period.

Follow-up questions

• What costs are being capitalized (labor, contractor time, overhead)?
• What criteria determine capitalization vs expense?
• Were policies changed mid-year? Who approved the change?

Confirm with

• Fixed asset roll-forward (beginning balance + additions − disposals = ending balance).
• Capitalization schedule showing projects, dates, amounts, and support.
• Amortization/depreciation schedule and useful life assumptions.

Category 3: Expense Classification Problems

1) Owner perks and personal expenses buried in operating costs

Observable symptoms

• Unusually high travel, meals, auto, “miscellaneous,” or subscriptions.
• Expenses that do not match business model (e.g., luxury travel for a local service business).
• Large “reimbursements” without documentation.

Follow-up questions

• Which expenses are personal vs business? Are reimbursements supported by receipts?
• Are there written expense policies and approval workflows?
• Are owner draws/salary structured consistently?

Confirm with

• General ledger detail for high-risk accounts (meals, travel, auto, entertainment, misc.).
• Expense report system exports; corporate card statements.
• Owner compensation summary (wages, distributions, reimbursements).

2) Misclassified payroll (COGS vs operating expenses) distorting margins

Observable symptoms

• Gross margin swings without changes in pricing or delivery model.
• COGS seems too low for a labor-heavy business (or too high for a product business).
• Payroll taxes/benefits not allocated consistently with wages.

Follow-up questions

• Which roles are treated as “direct” vs “indirect” labor?
• Are bonuses/commissions classified consistently?
• Are payroll taxes and benefits allocated using a consistent method?

Confirm with

• Payroll register by department/class; job-costing or time-tracking reports.
• Mapping document: roles → COGS or OpEx; allocation method for benefits/taxes.

3) One-time items treated as recurring (or recurring costs labeled “one-time”)

Observable symptoms

• Frequent “one-time” adjustments every period.
• Restructuring, legal, consulting, or “non-recurring” costs that keep repeating.
• Operating results look better only after adjustments.

Follow-up questions

• What qualifies as one-time? Is there a written definition?
• How often has this “one-time” category appeared in the last 6–12 months?
• Are these costs necessary to generate revenue (therefore effectively recurring)?

Confirm with

• Trend report of “one-time” accounts; vendor-level spend analysis.
• Contracts/SOWs for consultants; legal invoices and matter summaries.

Category 4: Balance Sheet Risks

1) Negative working capital without a clear operating cycle explanation

Observable symptoms

• Current liabilities exceed current assets and the gap widens.
• Cash feels tight despite reported profits.
• Short-term obligations (payroll taxes, credit lines, payables) dominate.

Follow-up questions

• Is the business model naturally negative working capital (e.g., paid upfront subscriptions) or is it stress-driven?
• Are payables being stretched beyond terms?
• Are customer prepayments/deferred revenue recorded correctly?

Confirm with

• Working capital schedule: AR days, inventory days, AP days by month.
• Deferred revenue roll-forward (beginning + billings − revenue recognized).
• Cash forecast for 13 weeks (to see near-term liquidity pressure).

2) Aging receivables and weak allowance (collectability risk)

Observable symptoms

• AR aging shows growth in 60/90+ day buckets.
• Allowance for doubtful accounts stays flat or near zero.
• Write-offs occur in bursts after long delays.

Follow-up questions

• Which customers are past due and why (disputes, service issues, customer liquidity)?
• What is the collections process and cadence?
• How is the allowance calculated (historical loss rate, specific identification)?

Confirm with

• Customer-level AR aging; dispute log; subsequent cash receipts after period-end.
• Allowance calculation worksheet and historical write-off rate.

3) Inventory build-up (demand risk, obsolescence, costing issues)

Observable symptoms

• Inventory grows faster than sales or seasonality would suggest.
• Gross margin looks stable while cash is strained (cash tied up in stock).
• Few or no inventory write-downs despite slow-moving items.

Follow-up questions

• Is inventory growth planned (new product launch, bulk buy) or unplanned (slow sales)?
• How do you identify obsolete/slow-moving items?
• Are overhead and freight being capitalized into inventory consistently?

Confirm with

• Inventory aging/turn report; slow-moving list; stockout/backorder metrics.
• Cycle count results; write-down policy and history.
• Inventory valuation method and any changes.

4) Ballooning payables (vendor strain and hidden financing)

Observable symptoms

• Accounts payable (AP) rises sharply while purchases are flat.
• Vendors place the company on hold or require prepayment/COD.
• Late fees, rush shipping, or supply disruptions increase.

Follow-up questions

• Are you paying vendors later than terms? Which vendors are most affected?
• Any disputes or unrecorded credits?
• Are there informal payment plans not reflected in the books?

Confirm with

• AP aging and trend; vendor statements; payment run history.
• Purchasing report by vendor; changes in vendor terms.

5) Covenant pressure and short-term debt risk

Observable symptoms

• Debt classified as current due to upcoming maturity or covenant breach risk.
• Frequent draws on line of credit; rising interest expense.
• Restrictions on cash, minimum liquidity requirements, or borrowing base limits.

Follow-up questions

• What covenants exist (DSCR, leverage, minimum cash)? Are you close to thresholds?
• Is there a borrowing base tied to AR/inventory quality?
• Any waivers requested or obtained?

Confirm with

• Loan agreement summary; covenant calculation worksheet; lender compliance certificates.
• Borrowing base report and eligibility rules (ineligible AR, inventory haircuts).

Category 5: Cash Flow Warning Signs

1) Persistent negative operating cash flow (even when profits look okay)

Observable symptoms

• Operating cash flow is negative for multiple periods.
• Cash declines while net income is positive.
• Working capital accounts (AR/inventory) absorb cash repeatedly.

Follow-up questions

• Is growth consuming cash (more AR/inventory) or is profitability overstated?
• Are collections slowing or inventory turning slower?
• Are there timing issues (large annual bills, payroll cycles) not planned for?

Confirm with

• Monthly cash flow trend; working capital schedule; collections metrics.
• Bridge: net income → operating cash flow with key drivers highlighted.

2) Reliance on financing to fund operations

Observable symptoms

• Cash increases mainly due to debt draws or equity injections.
• Operating cash flow negative, but company “survives” by borrowing.
• Rising interest expense and tightening liquidity.

Follow-up questions

• Is financing temporary (planned runway) or structural (operations can’t self-fund)?
• What happens if financing slows or terms worsen?
• Are there hidden obligations (factoring, merchant cash advances)?

Confirm with

• Debt schedule with maturities and rates; cash runway analysis.
• Bank statements and financing agreements; factoring/advance reconciliations.

3) Capex outpacing realistic growth (or maintenance needs ignored)

Observable symptoms

• Large capital expenditures without corresponding capacity expansion or revenue plan.
• Capex spikes while utilization remains low.
• Alternatively: capex is near zero for asset-heavy operations (maintenance deferred).

Follow-up questions

• Is capex tied to signed contracts, demand forecasts, or regulatory requirements?
• How much is growth capex vs maintenance capex?
• Are assets being replaced on schedule, or are breakdowns rising?

Confirm with

• Capex budget vs actual; project ROI assumptions; utilization metrics.
• Fixed asset register; maintenance logs; downtime and repair expense trends.

A Structured Investigation Method (Practical Workflow)

Step 1: Compare periods with a “why did it change?” table

Create a simple variance table for the last 3–6 periods. Focus on the biggest movers and ask for operational drivers.

Step 2: Reconcile statement linkages (quick consistency checks)

• AR linkage: Revenue on the income statement should generally relate to changes in AR and cash collections. If revenue rises but AR rises even more, investigate billing/collectability.
• Inventory linkage: If inventory rises, cash may fall and future margins may be at risk (write-downs). Tie inventory changes to purchasing and sales volume.
• Fixed assets linkage: Large increases in fixed assets should show up as investing cash outflows and later as depreciation/amortization.
• Debt linkage: Rising debt should appear as financing inflows, with interest expense increasing and covenant disclosures becoming more relevant.

Step 3: Review working capital schedules (AR, inventory, AP)

Ask for monthly schedules that show beginning balance, activity, and ending balance, plus aging/turn metrics. Your goal is to separate healthy growth from cash strain.

Working capital checklist (monthly): 1) AR aging + top past-due customers 2) Inventory aging/turn + write-downs 3) AP aging + vendors on hold 4) Deferred revenue roll-forward (if applicable)

Step 4: Examine notes and attachments (where red flags hide)

• AR aging: Look for growth in 60/90+ and concentration in a few customers.
• AP aging: Look for large past-due balances and stretched terms.
• Fixed asset schedule: Look for unusual capitalization and changing useful lives.
• Revenue detail: Credit memos, returns, discounts, and manual journal entries.
• Loan/covenant package: Covenant calculations, waivers, borrowing base.

Scenario-Based Checks (Identify the Red Flag + What Confirms It)

Scenario 1

What you see: Revenue is up 25% this quarter, but AR is up 60%. Operating cash flow is negative.

Likely red flag: Revenue quality issue (AR growing faster than revenue) and/or premature revenue recognition.

Confirm with: AR aging trend, subsequent cash receipts after period-end, invoice list for the last 2 weeks of the quarter, and any extended payment terms in contracts.

Scenario 2

What you see: Gross margin improved sharply, but fixed assets also jumped and depreciation is expected to rise next quarter.

Likely red flag: Inconsistent capitalization of costs (expenses moved to the balance sheet).

Confirm with: Fixed asset additions detail, capitalization policy, project list with supporting invoices/timesheets, and amortization schedule.

Scenario 3

What you see: Inventory increased every month for 5 months while sales stayed flat. No write-downs recorded.

Likely red flag: Inventory build-up and potential obsolescence.

Confirm with: Inventory aging/turn report, slow-moving SKU list, cycle count results, and write-down policy.

Scenario 4

What you see: AP doubled, and the company mentions “temporary timing differences.” Cash is stable only because payments slowed.

Likely red flag: Ballooning payables (vendor financing and liquidity stress).

Confirm with: AP aging, vendor statements, list of vendors on hold/changed terms, and payment run history.

Scenario 5

What you see: The income statement shows “adjusted earnings” excluding “one-time” consulting fees for the third quarter in a row.

Likely red flag: One-time items treated as recurring (earnings quality issue).

Confirm with: GL trend for consulting/legal accounts, vendor-level spend report, and copies of SOWs/contracts showing ongoing nature.

Scenario 6

What you see: Net income is positive, but operating cash flow is negative for 4 straight quarters. Financing inflows keep cash afloat.

Likely red flag: Persistent negative operating cash flow and reliance on financing to fund operations.

Confirm with: Monthly cash flow, 13-week cash forecast, debt schedule, and working capital drivers (AR/inventory changes).

Questions to Ask Your Accountant/Bookkeeper (Make Statements Decision-Ready)

Revenue recognition and revenue quality

• What is our revenue recognition policy (timing, delivery/acceptance, milestones)? Is it documented?
• How do we handle discounts, rebates, and returns—do we estimate reserves or record when incurred?
• Do we review period-end revenue entries for cut-off accuracy? Who approves manual revenue journals?
• Can you provide monthly revenue by customer/product and a credit memo/returns report?

Capitalization policies (what gets expensed vs put on the balance sheet)

• Which costs are capitalized (software/dev, implementation, equipment installs)? What criteria must be met?
• Do we capitalize internal labor? If yes, how is time tracked and approved?
• Can you provide a fixed asset additions schedule with supporting invoices and project descriptions?

Depreciation and amortization

• What useful lives and methods are we using (straight-line, accelerated)? Any changes this year?
• How do we decide when to retire/dispose assets? Are disposals recorded promptly?
• Can you share the depreciation/amortization schedule and reconcile it to the general ledger?

Expense classification and consistency

• Do we have a chart-of-accounts guide that defines what goes into COGS vs operating expenses?
• How are payroll, payroll taxes, and benefits allocated across departments/classes?
• What is our rule for “one-time” items? Can we tag and track them consistently?
• Can you provide GL detail for the top 10 expense accounts and highlight unusual vendors/transactions?

Working capital controls (AR, inventory, AP)

• Can you provide AR aging and AP aging monthly, with notes on major past-due items?
• What is our allowance for doubtful accounts policy and how is it calculated?
• How do we identify obsolete inventory and record write-downs?
• Do we reconcile subledgers (AR, AP, inventory) to the general ledger each month?

Debt, covenants, and liquidity

• What covenants apply and how close are we to thresholds? Can you share the covenant calculation?
• Are any liabilities due within 12 months that are currently classified as long-term?
• Can we maintain a 13-week cash forecast and update it weekly?